Pension Lump Sum vs Annuity: Discount-Rate Math

Your pension plan just sent you an election form with two choices: a $62,000-per-year annuity for life, or a $740,000 lump sum you can roll into an IRA. The annuity is simple — guaranteed income until you die. The lump sum is flexible — you control the money, invest it, and pass any remainder to heirs. But the number on the lump-sum line is not arbitrary. It was calculated using a discount rate derived from IRS-published corporate bond segment rates under IRC Section 417(e)(3), and that rate determines whether you are getting a fair deal, a generous one, or a shortchanged one. Understanding the discount-rate mechanics is the first step in making this decision with your eyes open.

How your plan calculates the lump sum

Under IRC Section 417(e)(3), defined-benefit pension plans must use a set of three segment rates published monthly by the IRS (based on IRS Notice 2024-76 and its annual successors) to convert an annuity stream into a present-value lump sum. These segment rates reflect the yields on investment-grade corporate bonds over a 24-month lookback window:

• First segment rate — applies to payments due within the first 5 years
• Second segment rate — applies to payments due in years 5 through 20
• Third segment rate — applies to payments due after 20 years

The plan takes your projected annuity payments, assigns each payment to the appropriate segment based on when it will be paid, and discounts each payment back to today using the corresponding rate. The sum of all discounted payments equals your lump-sum offer. A higher discount rate means each future payment is worth less today, producing a smaller lump sum. A lower rate means each future payment is worth more today, producing a larger lump sum.

Between 2020 and 2024, the IRS segment rates roughly doubled. The first segment rate moved from approximately 1.5% to over 5%. This means a retiree receiving a lump-sum offer in 2025 or 2026 is getting a significantly smaller check than someone with the identical annuity benefit would have received in 2021 — not because the pension is worth less, but because the discount rate used to convert it is higher.

The break-even age calculation

The central question in the lump-sum vs annuity decision is: How long do I need to live for the annuity to pay out more than the lump sum could have generated? This is the break-even age, and it depends on three variables: the lump-sum amount, the annual annuity payment, and the investment return you assume on the lump sum.

Based on a $740,000 lump sum vs $62,000/year annuity. Assumes lump sum is invested and $62,000/year is withdrawn annually. No taxes applied (both options are taxable at ordinary income rates when distributed). Break-even ages are approximate and shift with actual returns, inflation, and withdrawal timing.

The table reveals the core trade-off. If you are confident you will live past 82 and would invest the lump sum conservatively (3% to 5%), the annuity wins. If your health is poor or your family history suggests a shorter lifespan, the lump sum wins because any remaining balance at death passes to heirs. At a 7% return assumption, the break-even pushes past 88 — but earning 7% requires equity exposure, which introduces sequence-of-returns risk that could deplete the lump sum far faster than the table suggests if markets decline early in retirement.

Worked example: Karen and Tom, both age 63

Karen is retiring from a Fortune 500 manufacturer with a defined-benefit pension. Her election packet offers:

• Single-life annuity: $62,000/year ($5,167/month) starting at age 63
• Joint-and-75% survivor annuity: $55,800/year ($4,650/month) — 75% ($3,488/month) continues to Tom if Karen dies first
• Lump sum: $740,000 (calculated using 2025 segment rates)

Their other retirement resources: Karen has a $180,000 traditional IRA (rolled from a prior 401(k)), Tom has a $320,000 401(k) and a $45,000 Roth IRA, and they have $110,000 in a joint taxable brokerage account. Their combined Social Security benefits at age 67 (FRA) are projected at $52,000/year ($31,200 Karen, $20,800 Tom).

Scenario A: Take the annuity with 75% survivor

Karen elects the joint-and-75% survivor option at $55,800/year. At age 67, when both claim Social Security, their guaranteed income is $55,800 + $52,000 = $107,800/year. This covers their $85,000 annual spending with $22,800 to spare — enough to cover taxes on the pension and Social Security distributions. Their IRA and 401(k) balances ($500,000 combined) can grow largely untouched until RMDs begin at age 73, and they can execute modest Roth conversions in the gap years (ages 63 to 66) before Social Security begins, when their MAGI is lower.

If Karen dies at 78, Tom receives 75% of the pension ($41,850/year) plus his own Social Security (or Karen’s higher survivor benefit). His guaranteed income floor remains above $60,000/year for life. The remaining IRA and 401(k) balances provide supplemental income and a legacy.

Scenario B: Take the $740,000 lump sum

Karen rolls the $740,000 into a traditional IRA via direct rollover under IRC Section 402(c). Their combined traditional IRA and 401(k) balances are now $1,240,000. Before Social Security begins at 67, they have no pension income — their MAGI is lower, creating a large Roth conversion window. They convert $60,000/year for four years (ages 63 to 66), moving $240,000 to Roth while staying in the 22% bracket and below the first IRMAA threshold.

At age 67, Social Security provides $52,000/year. They withdraw $33,000/year from the traditional IRA to reach their $85,000 spending target. Their remaining traditional balance at age 73 (after conversions and withdrawals, assuming 5% growth) is approximately $780,000. The first-year RMD at 73 is roughly $29,400 — manageable, but their total MAGI (Social Security taxable portion + RMD + brokerage income) could approach IRMAA thresholds depending on investment returns.

If Karen dies at 78, Tom inherits the full IRA balance — approximately $650,000 to $700,000 depending on withdrawals and returns. But he has no guaranteed pension income, Social Security drops to the higher of the two benefits (approximately $31,200/year as survivor), and he must manage the IRA withdrawals himself for potentially 20+ more years.

The verdict for Karen and Tom

With both spouses in good health and a family history of longevity into the mid-80s, the annuity with 75% survivor provides a guaranteed income floor that covers base expenses for both lifetimes. The lump sum offers more flexibility and a larger legacy if one or both die early, but it transfers longevity risk, investment risk, and behavioral risk to the household. For this couple, the annuity is the stronger default — particularly because their existing IRA and 401(k) balances provide the flexibility and growth potential that the lump sum would have offered.

PBGC protection: what it covers and what it does not

The Pension Benefit Guaranty Corporation insures private-sector defined-benefit plans. If Karen’s employer’s plan terminates (bankruptcy, underfunding), the PBGC pays her annuity up to the statutory maximum — approximately $81,000/year for a 65-year-old retiree in 2026. Karen’s $55,800 annuity is well within this limit, so the PBGC backstop fully covers her benefit.

But PBGC protection has real limits. The maximum is reduced for early retirement (approximately $52,650/year at age 60). Certain benefit increases adopted within the last five years before plan termination may not be fully guaranteed. And if your pension exceeds the PBGC maximum — some long-tenured executives at large companies have pensions of $150,000 or more — the excess is at risk. For retirees whose benefits exceed the PBGC cap, taking the lump sum eliminates this counterparty risk entirely: once the money is in your IRA, the plan’s funded status is irrelevant.

You can check your plan’s funded status on its most recent Form 5500 filing, available at the Department of Labor’s EFAST system. Plans below 80% funded ratio deserve careful evaluation — though even severely underfunded plans are typically assumed by the PBGC at the guaranteed level.

Tax mechanics of the lump-sum rollover

A direct rollover of the pension lump sum to a traditional IRA under IRC Section 402(c) is tax-free. The plan writes the check to your IRA custodian (e.g., “Fidelity FBO Karen Smith IRA”), and no withholding applies. The full $740,000 arrives in the IRA.

If you take an indirect rollover — the plan sends the check to you — the plan must withhold 20% ($148,000 on a $740,000 distribution). You then have 60 days to deposit the full $740,000 into an IRA. You must come up with the $148,000 withheld from your own funds, or the shortfall is treated as a taxable distribution (and potentially subject to a 10% penalty if you are under 59½). The withheld amount is recovered when you file your tax return, but the cash-flow crunch is real. Always use a direct rollover.

Rolling the lump sum into a Roth IRA is legal but triggers the full $740,000 as ordinary income in one tax year. At the 24% bracket (married filing jointly income of $201,050 to $383,900 in 2026), the federal tax alone is roughly $177,600 — plus potential state taxes and the near-certainty of triggering the highest IRMAA tier two years later. A multi-year Roth conversion ladder after the traditional IRA rollover is almost always more tax-efficient than a single Roth rollover of the entire lump sum.

The 2026 interest-rate environment and what it means for your offer

As of early 2026, the IRS segment rates remain elevated compared to the near-zero environment of 2020–2021. The first segment rate is approximately 5.0% to 5.3%, the second approximately 5.2% to 5.5%, and the third approximately 5.4% to 5.7% (these shift monthly based on the corporate bond yield lookback). This means lump-sum offers are 15% to 25% lower than they would have been three to four years ago for the same annuity benefit.

Should you wait for rates to drop? If your plan allows you to defer your election (not all do — some require election within 90 to 180 days of separation), a drop in segment rates would increase your lump-sum offer. But you are making a bet on interest-rate direction, giving up annuity payments in the interim, and losing the opportunity to begin Roth conversions or invest the lump sum. For most retirees, the cost of waiting (foregone income, additional years of work, or delayed retirement spending) exceeds the potential gain from a modestly larger lump sum.

Decision framework: when each option wins

The annuity is stronger when: you and your spouse are in good health with family longevity into the 80s or beyond; the pension is within PBGC limits; you have other assets (IRA, 401(k), taxable) that provide flexibility and growth; the surviving spouse needs guaranteed income and has limited investment experience; or you value simplicity and certainty over optimization.

The lump sum is stronger when: your health is poor or family history suggests a shorter lifespan; the pension exceeds PBGC limits and the plan’s funded status is concerning; you have significant investment experience and a disciplined withdrawal plan; you want to leave a larger legacy to heirs; the pre-RMD Roth conversion opportunity is valuable enough to justify the added complexity; or you have no spouse or dependents who need survivor income.

Key takeaways

• Your pension lump-sum offer is calculated using IRS segment rates under IRC Section 417(e)(3), which are derived from investment-grade corporate bond yields over a 24-month lookback. Higher rates produce smaller lump sums. The 2025–2026 rate environment has compressed lump-sum offers by 15% to 25% compared to 2020–2021 — but the underlying annuity benefit is unchanged. Do not confuse a smaller lump sum with a less valuable pension.
• The break-even age — how long you must live for the annuity to pay out more than the invested lump sum — ranges from approximately 74 (if you earn 0% on the lump sum) to 88 or beyond (at 7% returns) for a typical $740,000 lump sum vs $62,000/year annuity. If your health and family history point to living well past 80, the annuity’s guaranteed income for life has significant value that a portfolio cannot fully replicate.
• PBGC insurance covers private-sector pension annuities up to approximately $81,000/year at age 65 in 2026, reduced for earlier retirement. If your annuity is within this limit, the PBGC backstop substantially mitigates employer credit risk. If your benefit exceeds the cap, the lump sum eliminates that counterparty exposure.
• Always use a direct rollover (plan-to-IRA custodian) when taking the lump sum. Indirect rollovers trigger mandatory 20% withholding, a 60-day deposit window, and an out-of-pocket cash-flow gap. Rolling directly to a Roth IRA makes the entire amount taxable in one year — a multi-year Roth conversion ladder from a traditional IRA is almost always more tax-efficient.
• Survivor benefits are the most underweighted factor in this decision. A joint-and-survivor annuity guarantees income to the surviving spouse for life regardless of market conditions. The lump sum passes a remaining balance to heirs, but only if there is a remaining balance — longevity risk, poor returns, or overspending can erode it. Households where one spouse manages all finances should weight the annuity’s survivor guarantee heavily.