Insights into an Important Decision
Most retirement plans today are defined contribution plans which promote an expectation of the potential for a large account balance. Some offer the option to convert that balance into a lifetime income, but most do not. Retirees who want a lifetime income stream can always make that choice by buying an annuity. However, most do not.
Taking the account balance as a lump sum gives the individual control over their investments and the flexibility about when they spend their money. But does this produce a good result for supporting them throughout their retirement? The MetLife has studied the results of lump sum choices in its 2017 and 2022 Paycheck or Pot of Gold studies. The bad news is that many retirees did not have a good result from choosing a lump sum. The 2022 study showed that one in three retirees who took a lump sum from their defined contribution plan have depleted their lump sum, on average, in just five years. This was an increase from 2017 when it was reported that one in five retirees who took a lump sum depleted it in an average of 5.5 years. For comparison, the average retiree can be expected to live about 20 years or more after retirement. So MetLife’s findings are particularly troubling in that it is in the later years of retirement when people are most likely to need additional income and would have the most difficulty working to earn additional income.
The MetLife study covered retirees who elected annuities as well as those that took a lump sum, and showed that some retirees were happy with their decisions and others were not:
· Of those who took the lump sum, 43% agreed strongly or somewhat with the statement “I believe that I would be better off financially if I had chosen to receive monthly annuity payments from my defined contribution plan.”
· Of those who took the lump sum, 83% agreed strongly or somewhat with the statement “I believe that I have more control over my finances because I did not take annuity payments from my defined contribution plan.”
· Of those who took the lump sum, 41% agreed strongly or somewhat with the statement “It would be easier for me to pay for basic necessities if I had chosen to receive monthly annuity payments from my defined contribution plan.”
· Of those who received the annuity, 96% agreed strongly or somewhat with the statement “I am happy that I chose to receive my defined contribution plan as monthly annuity payment that are guaranteed for life rather than periodic withdrawals or a large withdrawal from the account.”
· Of those who received the annuity, 36% agreed strongly or somewhat with the statement “I wish had access to more of my money to spend or travel than the monthly annuity payments provide.”
Responding to the Research
The Society of Actuaries Research Institute Aging and Retirement research has consistently shown gaps in knowledge about retirement planning and that many people have a short planning horizon even though retirement can last a long time. That research also shows that many people do not consider unpredictable expenses in their planning. The report “How People Plan for Retirement” summarizes research from several studies.
The decision to take a lump sum, an annuity or another method of payout is a complex one that involves trade-offs and variations in options available.
The Society of Actuaries Research Institute offers a series of Decision Briefs to help retirees with key decisions at the time of and during retirement. The brief Designing a Monthly Paycheck for Retirement, provides an overview of common major types of payment options and explains the trade-offs between them. It is important to recognize that the best payout strategy for any particular individual depends on individual circumstances. For many people the choice of a payout option is a major retirement decision.
The brief Lump Sum or Monthly Pension: Which to Take? specifically deals with the lump sum decision and the considerations to be taken into account in making this decision. As discussed in that brief, there are advantages and disadvantages to taking either the annuity or the lump sum option.
Some of the disadvantages of choosing an annuity option include:
- The decision to opt for or buy an annuity is irrevocable.
- The total benefits received may be smaller than a lump sum distribution if the retiree dies at a younger age since monthly payments may stop at death unless the retiree selects an option with continued payments such as survivor protection, a period certain, or a return of premium option.
- The value of the future pension payments is not available on demand if the retiree needs or wants to fulfill a dream or for extraordinary expenses.
Some of the disadvantages of choosing a lump sum option include:
· Depending on spending patterns, the lump sum assets may become depleted long before the retiree dies. The MetLife study showed 1/3 of those who took lump sums depleted them in an average of 5 years.
· A retiree who takes a lump sum will need to invest and manage the funds or perhaps hire someone to help, yet there is no guarantee of success.
· Lump sum balances are readily available and therefore vulnerable to scams, poor investment returns, bankruptcy, poor spending decisions, or extraordinary expenses that can also deplete the account that is intended to fund retirement expenses.
· If the lump sum account is fully depleted, the retiree may have no guarantee of monthly income beyond Social Security.
· A lump sum from a tax deferred retirement account that is not rolled over into an Individual Retirement Account is fully taxable immediately in the year it is paid.
In summary, the decision to take a full lump sum payment of the account balance should be made considering the security of the retiree considering both the near term and the longer term.