Lump Sum vs Annuity Pension: All You Need To Know

  • December 4, 2023
  • malikshehu
  • 8 min read

There are two types of pension plans: 

  1. Defined benefit – A defined benefit (DB) pension plan guarantees a specific retirement benefit based on factors such as your salary, years of service, and age.
  2. Defined contribution – A defined contribution plan is where you contribute a certain portion of your salary into an account. Your contributions are typically invested, often in stocks, bonds, or mutual funds. The value of the account depends on the contributions made and the performance of the investments.

In both plans, when you retire, you can take your money as a lump sum, or periodically, as an annuity.

Lump sum payment: Getting your pension all at once

Imagine receiving your entire retirement savings in one shot. This can be pretty great for a few reasons:

  1. Control over money: It puts you in charge right away. You can decide how to use this cash—whether it’s investing it, dealing with debts, starting a business, or making big purchases.
  2. Chance for higher profits: If you’re savvy about investing, a lump sum can potentially grow more than a regular pension payout. By smartly investing in things like stocks, bonds, or real estate, you might make more money in the long run.
  3. Flexibility: You’re free to use the money however you want. It’s not tied to any strict rules like a regular pension, so you’ve got more options.

But, there are some things to think about before jumping into a lump sum:

  1. Investment know-how needed: Handling a big sum needs some financial know-how. If you’re not careful, you could end up losing money instead of making it. This could put your future security at risk.
  2. Running out of money: If you live a long time or if your investments don’t perform well, you might use up all that cash. Without a regular income, this could be a problem later on.
  3. Tax: Taking a lump sum might mean paying more taxes upfront compared to getting regular payments. Tax laws and your personal situation play a big role here.

Deciding on a lump sum isn’t just about the money; it’s about understanding your goals, how much risk you’re comfortable with, and if you’re ready to handle the responsibility. 

While it offers control and potential for growth, it’s important to plan carefully for the long term and be aware of the risks involved.

Annuity payment: Getting regular income

An annuity payment is like getting a paycheck regularly but from your retirement savings. It can be fixed or changed over time and usually lasts your whole life or a set period. 

There are some good things about this option:

  1. Reliable income: An annuity gives you a steady income, kind of like a salary, even after retirement. You know how much you’re getting regularly, which helps cover everyday expenses without worrying about market ups and downs.
  2. Simplicity: Once you set it up, an annuity runs on its own. You don’t need to watch investments or do much—it’s hands-off. That makes it great for folks who want a simple retirement income.
  3. Safety net for life: Annuities protect you from running out of money. With a lifelong one, payments keep coming no matter how long you live, ensuring you’re financially covered.

But, there are some things to think about before picking an annuity:

  1. Lack of flexibility: Annuities aren’t flexible once you’ve set them up. You can’t change how often you’re paid or tweak things once the deal is done.
  2. Potentially lower returns: Annuities might not make as much money as a smart investment plan. They often offer fixed returns that might not grow as much as other investments.
  3. Lack of control: When you go for an annuity, you give up control over your lump sum. It turns into regular payments, which might not suit folks who prefer managing their money more actively.

Annuities promise a stable income, securing your finances in retirement. They give peace of mind against outliving your savings, but they might not give the flexibility or potential for big profits that some people want from their retirement funds.

What should you pick?

The thing about personal finance is that it’s personal. This means that what works for you might not work for the next person. So when deciding whether to choose a lump sum or annuity, here are five factors to consider. 

Your personal financial situation

If you’ve got urgent stuff like big debts or hefty expenses, a lump sum could help. Picture clearing your loans with a lump sum and starting retirement debt-free. 

If you’re planning big things, like starting a business or funding your grandchild’s education, a lump sum might give you the cash to make it happen. 

Say you love the idea of starting a business; the lump sum could be your ticket to invest. But if you’re relying on a steady income in the future and don’t have any passive income now, an annuity might suit you better. 

An annuity can provide that regular income flow you’re missing, like from property rentals or shares that pay dividends.

Life expectancy and health

Check how healthy you are and how long your family tends to live.

If your family is known for living long lives, an annuity might suit you better. It keeps paying no matter how long you’re around, giving you peace of mind about income, even in a long retirement.

But if health issues run in your family or you’re unsure about how long you’ll live, a lump sum might be more tempting. Imagine using that money earlier in retirement, especially if you might not live as long.

Risk tolerance and macroeconomics

Think about how comfortable you are with risks and market ups and downs.

If you like stability, choose an annuity. If you’re not keen on market changes and prefer a steady income, an annuity might be your thing. It’s a reliable paycheck for someone who likes predictable money over investment risks.

If you can handle risk, go for a lump sum. If you’re confident about investing and don’t mind the ups and downs, a lump sum might be more appealing. Think of it like a chance for bigger gains if you’re comfortable with investment risks.

Market volatility matters. When markets are shaky, annuities might look good as they’re not affected by market drops. But in booming times, a lump sum could offer chances to make more through investments.

Watch out for inflation: Annuities might not keep up with inflation, which could mean your money buys less over time. For a longer retirement, a lump sum might handle inflation better through smart investments.

Tax implications

Evaluate tax implications for both options. Depending on the country and tax laws, one option might offer better tax advantages than the other.  

The tax levied on both is normally the income tax rate. In Botswana, the highest income tax rate is 25%.

Spousal benefits

Last but not least, think of your spouse. 

Considering survivor benefits, an annuity ensures ongoing support for a partner after the retiree’s death, while a lump sum offers flexibility but might compromise the partner’s long-term financial security.

Here are different plans for spousal support:

Single-life annuities

These annuities offer the highest monthly payout, but the payments stop when the recipient passes away. They’re great for individuals without dependents or those who expect to outlive their spouse, maximizing personal benefits.

For example, if Mark is retired and getting annuity payments, he’d get the maximum payment because when he dies, no benefits go to his spouse, Julia. So if he’s getting 2,000 a month from annuities, the 2,000 stops at his death. 

Joint and survivor plans

These provide lower monthly payments compared to single-life annuities, but ensure a surviving spouse continues to receive a percentage of the benefits after the annuitant’s death. These plans are favored for married couples or when one spouse is older or healthier.

For example, if Mark chooses this option, he gets less than the maximum of 2000. If he agrees to a 50% joint and survivor plan, then he gets 1,000. When he passes away, Julia starts receiving the other 1,000 for the rest of her life. 

Term Certain/Period Certain Annuity

These annuities offer higher payments than joint-and-survivor plans. They pay out for a specific duration, even if the annuitant passes away, ensuring a designated beneficiary receives payments. They’re suitable when there’s a specific income requirement for a fixed period.

For example, if Mark has a 20-year Term Certain Annuity getting 500 monthly, and passes away after 10 years, Julia gets the remaining payments for the next 10 years.

It’s a personal choice

The correct decision will be based on your health, family, risk appetite, goals, current financial situation, the laws and regulations in your country, and other factors. 

Some countries allow you to have both options, where you take part of your pension as a lump sum and turn the rest into an annuity. If you choose that option, you’ll still have to look at the considerations above. 

Whatever you choose should give you peace of mind. Some people might find security in knowing they have a guaranteed income with an annuity, while others might feel more empowered managing their finances with a lump sum.

Speaking to a financial advisor can help turn hard decisions into rational ones. If you are retiring soon, consider speaking to one today.  

Malik Shehu is a Chartered Financial Analyst who works with pension funds and private clients on long-term investment strategies. Get in touch with him here