What annuity option should I choose?

I am approaching the age of retirement after a career in teaching, and I have a couple of options for taking my pension. One option is to take a single life annuity benefit of $1,040 per month. The other option would give me a lump sum of $35,320 plus a reduced monthly benefit of $793. Which one would be better for me?

The best answer will depend on your unique set of circumstances. A general rule of thumb is to base this choice on your life expectancy. If you live for many years, you’ll collect more by taking the larger annuity. If you live for relatively few years, you’ll collect more with the lump sum.

There are two main risks involved in this choice. One is that you might live a very long time. The other is inflation. Unless your annuity payment is protected by a cost-of-living adjustment, inflation will erode your monthly income over time.

The first risk is one you can transfer to your employer or, quite likely, an insurance company from which your employer will buy an annuity contract. Your monthly payment will continue no matter how long you live.

The risk of inflation is harder to deal with. If you assume inflation of 3.5 percent, after 20 years that $1,040 payment will be worth only $522 in 2010 dollars.

You can partly offset that inflation risk by taking the smaller payment and the lump sum, which you can invest. You could supplement the lower monthly payment by withdrawing $247 every month to equal the $1,040. In order to sustain those withdrawals for 30 years, you would need to earn a 7.5% annualized return on the lump sum. That would require the moderate risk level of a balanced portfolio. If your return were higher, you could withdraw more in order to keep up with inflation.

In the end, the choice you’re facing is a balancing act that depends on how long you expect to live and how comfortable you are in making investment decisions.