Pension: Lump sum or monthly payments for life?

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NEW YORK (Money) -- Question: I'm 57 and have a defined pension plan at work. At age 62, I can retire with a lump payment of just over $831,000 or I can get a monthly annuity payment of almost $5,400 for the rest of my life. What should I consider in choosing between these two options? --Bob Rozak, Germantown, Maryland

Answer: You've got a few years before you have to make your decision. But it's smart of you to start thinking about it now so you can weigh your options and come up with a sensible plan.

The lump sum vs. annuity choice comes down to how much you prefer the security of a monthly check for life vs. the flexibility of investing a lump sum and using the money as you need it. But that's vastly oversimplifying the issue, as each of these options comes with a whole set of pros and cons.

Getting a check-a-month as long as you live may sound ideal, especially given what's happened in the market over the past year. But that income stream is rarely adjusted for inflation (at least with corporate pensions) and monthly payments could put you at a disadvantage should you need access to a large amount of cash later.

The lump sum gives you more maneuvering room and provides a ready stash to cover unexpected expenses or to pay for the occasional splurge. But if you're not careful about how you spend and invest -- or even if you are careful, but the financial markets slump -- you could run through your money early and jeopardize your security later on.

I think you'll be able to come to a reasonable decision that makes sense for you, if you follow these five steps:

1. Check in with HR. The first thing you want to do is talk to someone in your company's human resources or benefits department to be sure you know all your options. Among the questions you want to ask: How is the lump sum amount calculated? Is there any way to take a portion in a lump sum and the rest in an annuity? How much would the amounts change if you put off taking the pension a couple of years? How about if you work longer? In some cases, you may be able to qualify for a much larger benefit by staying on just a few more years.

You should also know that if you're married, the law requires that you take your defined benefit pension in the form of a qualified joint survivor annuity (QJSA), an arrangement that provides payments over your lifetime and your spouse's. The payment your spouse receives must be at least half the benefits you receive. If you want to take your pension in some other form, both you and your spouse must sign a waiver.

You might also check out the online booklet What You Should Know About Your Retirement Plan from the Department of Labor's Employee Benefits Security Administration.

2. Get a handle on your income needs in retirement. Before you can decide how much of your benefit you want in monthly income vs. assets you can draw on, you've first got to have an idea of how much income you'll need. The best way to do that is to create an actual budget that estimates all the expenses you'll face in retirement. You could do that with a pencil and pad, but you're better off doing a digital version so you can revise it as your situation changes. With the retirement budget worksheet that's part of Fidelity's Retirement Income Planner, you can set up dozens of individual expense categories and also allow for different rates of inflation for different expenses.

One tip: To the extent you can, divide your expenses into two broad areas: necessities and discretionary spending. Doing this will help in two ways: first, it will give you a sense of how much wiggle room you'll have for cutting back if your financial situation deteriorates; second, it may help you decide how much regular income you absolutely need. Many people prefer to have much of their basic expenses covered by Social Security and other sources of assured income. If your estimated Social Security benefit (which you can estimate here) covers most of your basic expenses, then you may not need much more guaranteed income, if any at all.

3. Decide how much you'll want for unexpected expenses and big expenditures. This is a toughie. If you knew what unexpected expenses were coming, they wouldn't be unexpected. But the idea is to get at least a sense of how large a pool of assets you might need to dip into for things like medical costs later in retirement, upkeep of your home, help for your children and grandchildren, or the occasional splurge.

If you have enough assets in a 401(k), IRA or other retirement account that you can fall back on for this sort of thing, fine. You don't have to factor this consideration into your decision to take your defined benefit pension as income or a lump. But if you have very little in savings or other resources (home equity, cash value life insurance, etc.) that you could tap to meet an expense you can't handle from your monthly income, then you'll definitely want to consider the lump sum.

4. See if your company's pension payments are competitive. I've noticed that the monthly payments companies offer often compare quite favorably to the lifetime payments one would get by taking a lump sum and buying a lifetime annuity (aka, an immediate or income annuity) from a private insurer.

But that's not always the case. So you'll want to compare the deal your company is offering versus what you would get from an insurance company. If a private insurer is offering a higher payment for a given sum, you might want to take the lump sum, roll it into an IRA and then convert all or some of it into an immediate annuity.

Make sure you're comparing apples to apples, though. In other words, if you're considering a lifetime annuity on just your life, get a quote on a similar annuity from an insurer. If you're thinking of an annuity that will pay as long as you or your spouse is alive, make sure to get a quote for a joint and survivor annuity (and, remember, the quote will differ depending on whether the payment remains the same for the surviving spouse -- i.e., 100% survivor payment -- or goes down -- say, 50% of the payment to the survivor).

Keep in mind too that the quote you get for an income or immediate annuity will generally change week to week as interest rates fluctuate. So be sure you're making your comparison on the most recent information.

5. Decide if you're comfortable relying on your company for the rest of your life. If you take your pension in monthly payments, you're counting on your company's ability to make those payments for the rest of your life, or even longer. Given the fact that even one-time titans of the financial world can find themselves scrambling for survival, there's always the possibility that your employer (or a firm that acquires your employer) could have trouble meeting its pension obligations down the road.

That said, there are some protections. The Pension Protection Act of 2006 strengthens funding standards and has other provisions designed to assure that employee pensions are secure. In the event a company can't meet its pension obligations, the government's Pension Benefit Guaranty Corp. steps in. The PBGC's coverage has limits, however, so find out if your pension payment exceeds those limits.

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