Anna Rappaport, FSA, MAAA is a member of the Pension Research Council Advisory Board, and the chairperson of the Society of Actuaries Committee on Post-Retirement Needs and Risks.
Most retirement plans today are defined contribution (DC) plans, only a few of which offer retirees the opportunity to convert their balances into lifetime income streams. Retirees who want a lifetime income stream could buy an annuity, yet most do not.
Taking the DC account balance as a lump sum gives retirees control over their investments, and flexibility about when and how they spend their money. But that does not always enhance retirement security.
What Happens with the Lump Sums When People Take Them?
MetLife has examined what happens when retires take lump sum choices, most recently in its 2022 Paycheck or Pot of Gold report. The bad news is that many retirees did not do well after selecting the lump sum payouts. In fact, one in three retirees who took a lump sum from their DC plan depleted their lump sums in just five years on average. This was up from the 2017 report, where one in five retirees taking lump sums were found to deplete the money in around 5.5 years. For comparison, the average retiree can be expected to live about 20 years or more after retirement.
MetLife’s findings are particularly troubling, since it is in the later years of retirement that people are most likely to need additional income, yet they would have the most difficulty working to earn additional income. The 2020 study surveyed retirees who elected annuities as well as those that took lump sums, and it 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 (SOA) Institute has some insightful analysis showing where gaps arise in retirement planning. For instance, many people have a very short planning horizon, even though retirement can last a long time, and often retirees fail to consider unpredictable expenses in their planning. Also, 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 SOA article on 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 each individual will depends on individual circumstances.
Pros and Cons of Lump Sums
The SOA brief Lump Sum or Monthly Pension: Which to Take? specifically deals with the lump sum decision and factors that must be weighed when making this decision. There are advantages and disadvantages to taking either the annuity or the lump sum option. For instance, some disadvantages of choosing an annuity option include the following:
- 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:
- The lump sum may become depleted long before the retiree dies, depending on how quickly it is spent. If the lump sum account is fully depleted, the retiree may have no guarantee of monthly income beyond Social Security.
- 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.
- People taking lump sum balances are vulnerable to scams, poor investment returns, bankruptcy, poor spending decisions, or extraordinary expenses that can erode the money intended for retirement expenses.
- Lump sums withdrawn from tax deferred retirement accounts that are not rolled over into Individual Retirement Accounts are fully taxable immediately in the year they are paid.
In summary, the decision to take a full lump sum payment of one’s DC pension balance at retirement must consider the retirees’ near term as well as longer term needs.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.
