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To Annuitize or Not, That Is the Question

By Dan Haut, CFP® CIMA®

For retirees, choosing the most optimal pension option deserves a rigorous analysis.

For many employees in the public and private sector who are facing the prospects of an imminent retirement, the decision of how to take their pension is rife with uncertainty.

On its head, the two most basic pension payout options are relatively simple to grasp. An individual can either a.) take a “life annuity” (e.g., periodic income stream) for the duration of their lifetime, or b.) take a lump sum. While these retirement options are simple to understand, the assessment of which option is optimal involves a more complicated analysis, both quantitative and qualitative in nature. Moreover, the analysis is performed within the context of multiple factors, some of which are correlated. We will discuss these factors a bit later in this article.

To be clear, there are many derivatives of the two most basic pension payout options (e.g., “period certain,” joint survivorship, “pop-up” provisions, etc.). However, for the sake of brevity, we will focus on the two basic options, which are to either take the life annuity (periodic income stream) or take the lump sum. Further, the goal of this article will be to provide a framework for *how* a financial planner evaluates the merits of both options.

Before we go into the decision-making process, it would be ideal to provide a quick definition of terms that you’ll encounter in the article.

What is a pension plan, and how is it unique from a defined contribution plan?

From the Latin word, “pensio,” or “payment,” a pension is a fund in which contributions are added during the employee’s work years.

Often called a “defined benefit plan,” the pension’s contributions are funded by and the risk is borne by the employer. This is distinct from a “defined contribution plan,” (e.g., 401k) in which the contributions are funded by (through salary deferral) and the risk is borne by the employee.

What is the difference between plan assets and pension benefit obligations?

The determination of whether a defined benefit pension plan is funded or not, depends on the difference between the plan assets and the plan obligations.

The plan’s assets are funded by employer contributions which get invested into a diversified fund of stocks, bonds, and other alternative assets like private equity or real-estate. The growth of the pension plan assets is predicated on the return of the underlying securities.

The pension benefit obligations are the liabilities of the employer, and they are predicated on actuarial assumptions like life expectancy, inflation, interest rate forecasts, etc.

While a bit simplistic, the goal is for the pension fund assets to exceed the pension fund obligations. Every year, the pension plan will experience either a surplus or deficit based on the changing of variables like actuarial assumptions, plan returns, benefits paid, etc.

Unfortunately, most US single and multi-employer pension plans, are underfunded. Per research from the Pew Trust (before the most recent passage of the Butch Lewis Act {The American Rescue Plan}), analysis of 100 Public Pension plans in 33 cities across the US demonstrated they had only 68% of the assets required to pay the pension liabilities.1

In fact, from the very first public pension plan (American Express Co) in 1875, the pension plan has long ebbed and flowed over time. For instance, while 50% of the private sector had a pension plan in 1960 (the height of labor union power), by 2006, that number shrunk to lower than one in four as companies rested more responsibility in the hands of employees to fund their retirement.2

How are life annuity benefits calculated?

There is usually a set “benefit formula” that determines each annuitant’s final pension amount. A traditional pension plan is known as the FAP, or final average pay plan, where the average salary over the remaining five years is used.

Let’s use an example to illustrate, which we will come back to over the course of the article.

Our fictitious employee, Premesh Singh (65 years old) has worked at the city of Osborne for 30 years. Let’s assume that the city of Osborne will pay 2% of the number of years that Premesh works, or 60% of his highest salary. If his highest salary was $100,000 before he retired, the City of Osborne will pay him $60,000/year.

How Lump Sum Calculated

Before I explore how a decision should be evaluated (lump sum vs. life annuity), it is important to understand the math of how a lump sum is even calculated by the plan actuaries.

In short, the lump sum is simply the present value of the discounted future pension streams or life annuity. While a bit reductive, plan actuaries use life expectancy tables (based on age of annuitant) and discount the future pension income streams at a discount rate. The discount rate is usually contingent on where interest rates are and is based on an interest rate index plus a spread.3

Let’s go back to our fictitious friend, Premesh, who works at the city of Osborne.

Assuming the life expectancy of a 65 year old man is 21 years (age 86), the discount rate is 4%, and Premesh’s pension is $60,000, the present value of the lump sum would be $841,750.

Should I take the life annuity benefits or lump sum?

Like most things in life and finance, there is not a simple or “one size fits all” answer. However, let’s explore how your financial planner should perform the evaluation.

The first step is to estimate your life expectancy – again not an easy task. The life expectancy should be viewed in the context of one’s current health, family history, longevity, etc.

The second step is to calculate the internal rate of return (IRR) when comparing the life annuity relative to the lump sum. The IRR (aka “required discount rate”) is the return that is needed on each of these separate pension income streams to equal the lump sum that you are giving up.

In the previous case study, we established that the internal rate of return, based on Premesh’s life expectancy, is 4%. This discount rate of 4% is the required or minimum rate at which Premesh would be indifferent between choosing the lump sum or life annuity.

In other words, if Premesh had a lump sum of $841,750, and it grew 4% per year, he could pull out $60,000/year for 21 years before the account went to $0 at age 86. In short, assuming that Premesh could earn the 4% himself, he could “self-fund” his own life annuity with the lump sum.

The third step is to evaluate the opportunity cost of investing the lump sum. The opportunity cost is simply the return given up by taking the income vs. investing the lump sum. This is also not an easy task and somewhat subjective. The opportunity cost will be higher for aggressive investors with higher allocation towards equities, and lower for conservative investors with a higher allocation towards bonds.

Regardless, the goal is to juxtapose the IRR (required return) relative to the opportunity cost. Rule of thumb: if the opportunity cost > IRR, take the lump sum; if the IRR > opportunity cost, take the income stream.

Let’s look at Premesh Singh hypothetical again.

We’ll assume that Premesh is healthy and has longevity in his family. He expects to live at least another 21 years (age 86 life expectancy). Let’s also assume that his account has produced an average return of 7% (net of fees) since inception (20 years).

In this example, the opportunity cost of 7% is > than the IRR (4%) of the life annuity. Per the rule of thumb in our discussion, it makes sense to take the lump sum.

In fact, based on the math, if Premesh invests the lump sum of $841,750 and the account earns 7% per year, he can take a distribution of $77,684 for the next 21 years before the asset goes to $0 by age 86. In short, by investing the lump sum himself, he can earn $17,684 more per year ($77,684 vs. $60,000) than by taking the life annuity option. This is all due to a higher opportunity cost!

Even further, based on a 7% opportunity cost (vs. 4% discount rate), my trusty Texas Instruments calculator tells me that Premesh will have made $191,418 more over the course of the 21 years than by taking the life annuity. 

Of course, this is all very simplistic. In reality, investment returns can be lumpy and emotions can be volatile in concert with the stock market. For these reasons, relying only on the cold calculations of a non-sentient square of plastic and circuits (calculator) is not the best idea. There are other factors that you can and should consider with your advisor.

Other Factors to Consider

Understanding the IRR relative to the opportunity cost is a good first step in choosing to take the life annuity or lump sum. However, not every financial decision should be reduced to simple math.

Risk Profile: Security vs. Flexibility

For those who are more risk averse, an income stream offers more security, regardless of how markets perform. Having this income stream as a reliable source of income (to augment social security, etc.) can create a peace of mind that offers great utility.

For those who are more risk tolerant, the lump sum provides the flexibility to invest in a variety of investments that can produce a greater return, albeit with more volatility.

Credit risk of payee

Before deciding, it is also important to evaluate the credit risk of the company and/or municipality. Does the corporate pension plan have large unfunded liabilities? Is the city or municipality in financial distress or encumbered by a lot of debt? If both answers are “yes,” taking the lump sum could be the wise thing to do.

We have all heard the horror stories of companies that have filed for Chapter 7 or 11 bankruptcy. The corporate employees who had pension plans are often hurt the most. For example, in 2005, United Airlines, received court permission to terminate its four employee pensions plans. With $7.4 billion in claims and 123,957 participants, this failure was one of the largest plan terminations in US history.  Ironically, 5 of the top 10 largest corporate pension defaults in 2010 were airlines! And this was before the COVID-19 pandemic!4

Speaking of the pandemic, since March 2020, many cities experienced frozen or terminated pension plans as stay at home orders initially decimated revenue streams like sales and local income tax. Recent legislation has somewhat helped. Of course, many cities have been dealing with pension issues well before COVID. Before I had kids, my wife and I lived in Vallejo, CA for many years. Before the city filed for bankruptcy in 2008 (which Vallejo came out of), pay and benefit for firefighters and police officers were 80% of the general budget!

In short, your advisor should look at the credit worthiness of the corporation or city before a decision is made.

Recent legislation

Any reputable advisor should also review recent congressional laws to help with the decision. One question any employee should ask: “How does the legislative landscape help protect me should my plan go under-funded?”

Recently, and as part of President Biden’s fiscal stimulus, “The American Rescue Plan Act of 2021,” the Butch Lewis Multi-Employer Pension Plan Relief Act was signed into law. This act is way too complex to really sink our teeth into for the purposes of this article. Suffice it to say that it helped restore pensions for more than one million retirees and workers in 200-225 underfunded multi-employer plans.5

In fact, and well before this act, the ERISA Act of 1974 (Employee Retirement Income Security Act) established the Pension Benefit Guarantee Corporation (PBGC). Through the investment of plan premiums, the PBGC offers pensioners maximum protections, set annually. For 2019, the maximum amount guaranteed for those who are age 65 is $5,607.95.6

Inflation and interest rates

Another thing you should evaluate with your advisor before choosing pension options: inflation and interest rates.

When the COVID-19 vaccine was announced in November 2020, one thing that pretty quickly took hold was higher prices of goods and services (inflation). Whether it is lumber, semi-conductors, autos, food, gasoline, or services, currently the demand for goods and services is outstripping supply. Whether inflation proves transitory (per the Federal Reserve) or insidious (economist Larry Summers), this is a hot debate.7

The prospects of inflation and subsequently interest rates should be considered in the lump sum vs. life annuity decision.

For example, if our friend Premesh annuitizes during early stages of inflation cycle, his income is less valuable. With 3% growth in the CPI (Consumer Price Index), costs will double in 24 years. What happens to Premesh’s $60,000/year income? It stays the same.

With concerns about inflation, taking a lump sum could serve as a better inflation hedge versus an income stream.

Life Expectancy of Spouse and Joint Benefit Riders

The availability of joint benefit riders can also impact your decision. In this day and age, most pension plans offer a joint benefits rider to the annuitant. If the spouse is much younger than the annuitant, a joint benefit rider could be optimal over a lump sum as it will spread out income over a much longer period of time.

In fact, the longer the joint life expectancy (on surviving spouse), the more compelling the income annuity. The reason? The present value of the total income stream is higher the longer the second spouse outlives the first. Consequently, the discount rate (IRR) is also higher, and therefore one needs a higher opportunity cost to justify taking the lump sum.

For example, let’s look at another fictional client. Sonia Van Winkle (age 65), is married to a younger husband (her second marriage), Jay Van Winkle, who is age 45.  For her pension options, she is able to take a lump sum of $1,125,000 or a straight life annuity of $72,000/year. Assuming she lives until age 90, her IRR is 4%. This means that if she can earn this exact rate, she would be indifferent between either option (lump sum or annuity). In this scenario, Sonia is risk averse and opts for the life annuity.

We will assume that under the annuity option, she is given a choice to take a joint benefit rider. This rider will provide income to Jay should Sonia predecease him. For the sake of making this compelling, let’s imagine that Sonia is the sole breadwinner, and that Jay is a profligate spender. Consequently, she has structured her marital trust with limitations which restrict Jay from taking principal if she passes. She is worried that Jay will languish financially if she passes before him.

The 100% joint survivorship rider provides $62,000/year, which is less than the straight life annuity of $72,000 but continues upon Sonia’s death. If Sonia predeceases Jay, and he lives until 90, the IRR increases to closer to 5% by taking the joint ride option! More importantly, it will provide Jay with a steady stream of income.

In closing, there is a multi-process approach when choosing between taking your pension’s lump sum or life annuity. While there are many factors to consider (objective and subjective), your Osborne Partners Portfolio Counselor can help you make the best-informed decision for your unique situation.

1 Draine, David. “Municipal Pension Funding Increased in Recent Years, but Challenges Remain,” Published May 18, 2021,

2 Workplace Flexibility 2010. “A Timeline of the Evolution of Retirement in the United States,” Georgetown University Law Center. Published March 26, 2010,

3 “Fundamentals of Current Pension Funding and Accounting For Private Sector Pension Plans,” American Academy of Actuaries. Published July 2004,

4 Maynard, Micheline. “United Air Wins Right to Default on Its Employee Pension Plans,” Published May 11, 2005,

5 “What the Butch Lewis Act Will and Will Not Do,” Pension Rights Center. Published April 27, 2021,


7 Summers, Lawrence H. “Opinion: The inflation risk is real,” Published May 24, 2021,

Dan Haut, CFP® CIMA®

Daniel is a Portfolio Counselor for OPCM with nearly 15 years of experience in the financial services industry. Dan earned his Bachelor of Arts degree in Political Science from the University of California, Davis. He is a CERTIFIED FINANCIAL PLANNER practitioner and a CIMA® designee.
The opinions expressed herein are strictly those of Osborne Partners Capital Management, LLC ("OPCM") as of the date of the material and is subject to change. None of the data presented herein constitutes a recommendation or solicitation to invest in any particular investment strategy and should not be relied upon in making an investment decision. There is no guarantee that the investment strategies presented herein will work under all market conditions and investors should evaluate their ability to invest for the long-term. Each investor should select asset classes for investment based on his/her own goals, time horizon and risk tolerance. The information contained in this report is for informational purposes only and should not be deemed investment advice. Although information has been obtained from and is based upon sources OPCM believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. Past performance is not indicative of future results. Inherent in any investment is the possibility of loss.