Lump Sum vs. Regular Pension Payments: An Overview
So you are on the verge of retirement, and you are faced with a difficult choice regarding the defined-benefit pension plan you are fortunate enough to have: Should you accept the traditional, lifetime monthly payments or take a lump sum distribution?
Understandably, you might be tempted to go with the lump sum. After all, it may be the largest single disbursement of money you will ever receive. Before you make an irrevocable decision about your future, take the time to understand what the options might mean to you and your family.
"Social Security, taxes, life insurance, life expectancy, investments, and health need to be considered before making a choice," says Carlos Dias Jr., wealth manager, Excel Tax & Wealth Group, Lake Mary, FL.
- Pension payments are made for the rest of your life, no matter how long you live, and can at times continue after death with your spouse.
- Lump sum payments give you more control over your money, allowing you the flexibility of spending it or investing it when and how you see fit.
- It is not uncommon for people who take a lump sum to outlive the payment, while pension payments continue until death. If a pension administrator goes bankrupt, pension payments could stop, though PBGC insurance covers most people.
Lump Sum Payments
A lump sum distribution is a one-time payment from your pension administrator. By taking a lump sum payment, you gain access to a large sum of money, which you can spend or invest as you see fit.
"One thing I emphasize with clients is the flexibility that comes with a lump sum payment," says Dan Danford, CFP®, Family Investment Center, Saint Joseph, MO. A pension payment "annuity is fixed (occasionally COLA-indexed), so there is little flexibility in the payment scheme. But a 30-year retirement probably faces some surprise expenses, possibly large. The lump sum, invested properly, offers flexibility to meet those needs and can be invested to provide regular income, too."
Do you want to leave something to loved ones upon your death? Once you and your spouse die, the pension payments might stop. On the other hand, with a lump sum distribution, you could name a beneficiary to receive money after you and your spouse are gone, if any money is left.
Income from pensions is taxable. However, if you roll over that lump sum into your IRA, you will have much more control over when you remove the funds and pay the income tax on them. Of course, you will eventually have to take required minimum distributions from your IRA, but that won’t happen until age 70½.
"Rolling your pension into an IRA will give you more options," says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, MA. "It will give you more flexibility of investments that you can invest in. It will allow you to take distributions according to your RMD, which in many cases would be lower than your planned pension payments. If you want to minimize your taxes, rolling your pension into an IRA will allow you to plan when you take your distributions, thus you can plan when and how much you want to pay in taxes."
Regular Pension Payments
A regular pension payment is a set monthly payment received by retirees until death. Some pensions continue with the surviving spouse at that point, while others do not. Some pensions also include cost-of-living adjustments (COLA), meaning payments go up over time, usually indexed to inflation. Some plans do not include a COLA.
Some argue that the main feature people like about lump sum payments—flexibility—is the very reason to avoid them. Sure, the money is there if you have a financial need. But it also invites overspending. With a pension check, it is harder to splurge on purchases that you might later regret. In fact, a 2016 Harris Poll study of retirees revealed that 21% of retirement plan participants who took a lump sum depleted it in 5.5 years.
A lump sum also requires careful asset management. Unless you are putting the money into ultra-conservative investments (which probably will not keep pace with inflation), you are putting yourself at the mercy of the market. Younger investors have time to ride the ups and downs, but folks in retirement usually do not have that luxury.
And with a lump sum, there is no guarantee that your money will last a lifetime. A pension will pay you the same check each month, even if you live to a ripe old age.
"In an environment with low fixed-income interest rates and generally expanding life expectancies, the pension stream is generally the better way to go," says Louis Kokernak CFA, CFP, founder of Haven Financial Advisors, Austin, TX. "It is no accident that private and public employers are paring back those benefits. They are trying to save money."
You also need to think about health insurance. In some cases, company-sponsored coverage stops if an employee takes the lump sum payout. If this is the case with your employer, you will need to include the extra cost of health insurance in your calculations.
One downside of pensions is that an employer could go bankrupt and find itself unable to pay retirees. Certainly, over a period of decades, that is always a possibility.
Are there certain cases where this should affect your decision? Absolutely. If your company is in a volatile sector or has existing financial trouble, it is probably worth taking into consideration. But for most individuals, these worst-case scenarios need not be a major worry.
Keep in mind, though, that your pension benefits are safeguarded by the Pension Benefit Guaranty Corporation (PBGC), the government entity that collects insurance premiums from employers sponsoring insured pension plans. The PBGC only covers defined-benefit plans (stated payments) and does not cover defined-contribution plans (like 401(k) plans). It earns money from investments and receives funds from the pension plans it takes over. The maximum pension benefit guaranteed by PBGC is set by law and adjusted yearly. It’s true that this insurance is capped (in 2018, the maximum annual benefit is $65,045 for a 65-year-old retiree) but it should allay any fears that your whole retirement plan could go under. (The guarantee is lower for those who retire early or when the plan involves a benefit for a survivor. And the guarantee is increased for those who retire after age 65.) Therefore, as long as your pension is less than the guarantee you can be reasonably sure your income will continue if the company goes bankrupt.
First, you should ask yourself why your company would even want to cash you out of your pension plan. Employers have various reasons for offering the lump sum payment. They may use it as an incentive for older, higher-cost workers to retire early. Or they may make the offer because eliminating pension payments generates accounting gains that boost corporate income. Furthermore, if you take the lump sum, your company will not have to pay the administrative expenses and insurance premiums on your plan.
Before choosing one option or the other, it helps to keep in mind how companies determine the amount of lump sum payouts. From an actuarial standpoint, the typical recipient would receive approximately the same amount of money whether he chose a pension or a lump sum. The pension administrator calculates the average lifespan of retirees and adjusts the payment schedule accordingly.
That means if you enjoy a longer-than-average life, you will end up ahead if you take the lifetime payments. But if longevity is not on your side, the opposite is true. Those with a serious illness, for example, have a powerful reason to take the lump sum.
One approach might be to have it both ways: Put part of a lump sum into a fixed annuity, which provides a lifetime stream of income, and invest the remainder. But if you’d rather not worry about how Wall Street is performing, a stable pension payment might be the better way to go.