As employees covered by defined pension plans approach retirement, companies are looking for ways to remove themselves from their obligations by offering pension buyouts. For example, instead of providing the retired employee with an income stream for life, the company may offer the retired employee a lump sum instead.
To some retirees, that lump sum payment can be quite enticing. After all, the lump sum is going to appear as a much larger number than the monthly pension benefit, and it provides the retiree with 100% control over how and when to take withdrawals. Want more money now and less later? You can do that if you opt for the lump sum. And, if you and your spouse do not exhaust all your retirement assets, you can leave them to children or grandchildren.
One drawback to the lump sum option is that with 100% control comes 100% responsibility. You’ll have to decide where to invest that lump sum, which may include risking some of it in the market.
Not Much Flexibility With a Pension
A pension is simply less flexible. You don’t have the option to make your own investment choices, which could be good or bad depending on your preferences. Typically, you can’t increase or decrease your monthly benefits based solely on your lifestyle. If you need extra for a vacation or major medical expense, you will not be able to simply draw extra from the pension for those things. And, if you and your spouse pass away prematurely, there is usually no remaining benefit for your beneficiaries.
These are important factors to consider when given the option to take your pension as a lump sum. Here are four more specific things you can do to evaluate the attractiveness of your lump-sum offer.
1. Compare Using a 4% Withdrawal Ratio
To evaluate your offer, you need to compare apples to apples, as opposed to comparing an income stream amount to a lump sum. To do this, you’ll want to find out about how much income the lump sum would provide so you can compare it to your pension benefit.
The 4% withdrawal rule states that by maintaining a moderate portfolio, you can essentially withdraw 4% of your portfolio each year, adjusting for inflation, and avoid running out of money for 30 years. While the 4% withdrawal rule has its limitations, it may be a good place to start. (For related reading, see: The 4% Retirement Withdrawal Rule: What to Know.)
According to this rule, a lump sum offer of $750,000 would provide $30,000 per year in the first year. You can then compare this number with your pension benefit. Of course, keep in mind that if you invest the lump sum in the market, your income is not guaranteed, while your pension may be guaranteed.
2. Compare Using an Income Annuity
It seems there has never been a shortage of bad press for annuities of all kinds. But because there are so many types, it’s difficult to make a blanket statement about annuities, just as it is difficult (or even impossible) to generalize about any type of investment.
However, similar to a pension, an annuity can also provide a lifelong income stream. And, if you want to see if you can improve upon the pension benefit being offered, annuities are one place you could research. With an immediate annuity, you can start taking income right away. Deferred annuities can allow your benefit to grow until you begin taking payments. For risk averse investors, fixed annuities allow you to avoid the volatility of the stock market, but you should be prepared to give up some control and liquidity if you purchase one.
When you’re presented with a lump sum buyout offer, looking into what your income benefit could be through the use of an annuity is likely a prudent move.
3. Check the Funding Status of Your Pension
Regardless of how the math shakes out, you’ll always want to look into the strength and funding status of your pension to get an idea of the likelihood you will actually receive your stated benefit. In some cases, your pension benefit may mathematically blow the lump sum out of the water, but if the pension is unhealthy or not on track to be fully funded, that could be a major cause for concern. (For related reading, see: How Safe Is Your Pension?)
There is no magic percentage that tells you if the pension will fail, but some industry experts have historically used 80% as a benchmark. However, this article from the American Academy of Actuaries disputes the 80% funding standard and points to several other factors, including:
- Size of the pension obligation vs. the revenue, assets, and payroll obligations of the plan sponsor
- Financial health of the plan sponsor (measured by cash flow, total debt and profitability)
- Funding or contribution policy
- Investment strategy, including the level of investment volatility and the possible effect on contribution levels
- Contribution patterns and overall projection of contributions vs. withdrawals
Some of this information may be difficult to obtain, but it should certainly be part of your evaluation process with such an important decision.
4. Evaluate Your Health
Your health could play a major role in deciding whether to take a lump sum or not. Most of us don’t know how long we’ll live, but there are things that can help us estimate our longevity (personal health history, family history, etc.). Of course, if you are married, you’ll need to not only evaluate your own life expectancy, but also the life expectancy of your spouse, who would likely be receiving survivorship pension benefits.
If you don’t expect to live to a normal life expectancy and are not married, a lump-sum may allow you the chance to leave an inheritance for your children or other beneficiaries.
The decision to take a lump-sum or not is extremely crucial to your financial plan. There is certainly not a one-size-fits-all approach when evaluating your options, but these are all things to consider.
(For more from this author, see: Determining If You're Prepared for Retirement.)
Disclaimer: CarsonAllaria Wealth Management does not provide tax or legal advice. All articles and posts are provided by CarsonAllaria Wealth Management (CAWM or firm) for informational purposes only. By accessing or otherwise using this Article, you agree to be bound by the terms and conditions set forth below. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the Article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the Article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment strategy. In addition, this Article shall not constitute the provision of personalized investment, tax or legal advice, and investors shall not assume this Article serves as a substitute for personalized individual advice. Information contained in this Article may have been derived from third-party sources that CAWM believes to be reliable; however CAWM does not control such information and does not guarantee the accuracy or timeliness of such information and disclaims all liability for damages resulting from such sources. Links or references to third-party websites are provided as a convenience and do not constitute an endorsement by CAWM, and the Firm is not responsible for the content of any such websites. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.