So you're on the verge of retirement and you're faced with a difficult choice regarding the defined-benefit pension plan you're 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'll ever receive. Plus, you like the idea of having more control over your investments. 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, Fla.
Why Employers Offer the Choice
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.
Understanding the Guarantees
One of the knocks against pensions is that an employer could go bankrupt and find itself unable to pay retirees. Certainly, over a period of decades, that’s always a possibility.
Keep in mind, though, that your pension benefits are safeguarded by the Pension Benefit Guaranty Corporation (PBGC), the government entity that collects those 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.
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’s probably worth taking into consideration. That’s also the case if you have a large pension that significantly exceeds the PBGC benefit ceiling. But for most individuals, these worst-case scenarios needn’t be a major worry.
Why You Should Take the Lump Sum
The average rate of inflation is about 3% per year. Yet the cost of healthcare has gone up 5.5% during the same period. Does your pension include cost-of-living adjustments (COLA)? What are the increases based on, and will they reflect the actual amount you'll need to meet your expenses down the road?
Something that costs $1,000 today, for example, will cost $1,344 in 10 years, assuming 3% annual inflation. But what if your $1,000 in prescription drugs goes up 5.5%? You'll need $1,708 to pay the same bill in 10 years, and your pension might not have kept up. The pension fund manager's primary concern is making enough money to send you the required check each month. In many cases, the pension fund payments are not indexed to inflation, meaning they will not rise with inflation. But if you handled your portfolio, you could rebalance the assets based on inflationary trends and possibly have a better chance of boosting your income as the years go by.
"One thing I emphasize with clients is the flexibility that comes with a lump sum payment. [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," says Dan Danford, CFP®, Family Investment Center, Saint Joseph, Mo.
Do you want to leave something to loved ones upon your death? Once you and your spouse die, the pension payments will 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.
Income from pensions is taxable. However, if you roll over that lump sum into your IRA, you'll have much more control over when you remove the funds and pay the income tax on them – which could be never if you have sufficient income from Social Security checks or another pension, or if you plan to work part-time after you retire. Of course, you'll 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. 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," says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Mass.
Why You Should Take the Pension
Some argue that the main feature people like about lump sum payments – flexibility – is the very reason to avoid them. Sure, the money’s there if you have a financial need. But it also invites overspending. With a pension check, it’s harder to splurge on purchases that you might later regret. In fact, a 2016 Harris Poll study of retirees, Paycheck or Pot of Gold, revealed that 21% of retirement plan participants who took a lump sum depleted it in 5.5 years on average.
A lump sum also requires careful asset management. Unless you’re putting the money into ultra-conservative investments (which probably won’t keep pace with inflation), you’re putting yourself at the mercy of the market – and it's not getting any less volatile these days. Younger investors have time to ride the ups and downs, but folks in retirement usually don’t have that luxury.
And with a lump sum, there’s also 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. That’s especially important for women, who on average live longer than males.
Speaking of which, what about your spouse? If you opt for the pension, you can make sure that he or she will receive a steady income if something happens to you. But if you take the lump sum, will there be enough money to provide for your survivor? And will he or she be able to manage the funds as well as you? If you are in excellent health and members of your family live much longer than average, that could weigh in favor of a pension.
"In an environment with low fixed income interest rates and generally expanding life expectancies, the pension stream is generally the better way to go. It’s no accident that private and public employers are paring back those benefits. They are trying to save money," says Louis Kokernak CFA, CFP, founder of Haven Financial Advisors, Austin, Texas.
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'll need to include the extra cost of health insurance in your calculations.
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.
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’ll end up ahead if you take the lifetime payments. But if longevity isn’t on your side, the opposite is true. Those with a serious illness, for example, have a powerful reason to take the lump sum.
How to Evaluate the Offer
You're supposed to receive the same amount, but many employers don't provide side-by-side comparisons of the lump sum and pension payments options and fall short of giving the information you need to make an informed decision. Therefore, it's your responsibility to find out what the numbers mean. Here are some key questions to ask:
1. Is the value of the lump sum equal to the monthly pension payments over your estimated life expectancy?
2. Did your employer remove any early-retirement subsidies in calculating the lump sum offer? Typically, these subsidies are added to the value of pension benefits as incentives to entice workers to retire early, and they could be worth tens of thousands of dollars. If that amount is stripped out of the lump sum payment, you could be missing out on a lot of money.
3. Could you get a better return than the pension fund managers earn? Calculate how much you would need to earn using your lump sum payment to equal the benefits of the pension payments. For example, suppose you were offered $400,000 in lieu of a $2,500 per month pension. The breakeven point if you earned 0% on the lump sum would be 13 years ($400,000 ÷ $2,500 = 160 payments ÷ 12 = 13.3 years). But if you could earn 5% each year on your lump sum of $400,000, the money would last 22 years, assuming you spent $30,000 ($2,500 x 12) annually. But would this be long enough?
The Bottom Line
Putting the numbers aside, when you make your choice between the lump sum and the monthly pension payments, it should come down to this crucial question: How confident are you that you'll make the right decisions to convert that lump sum into a stream of income that will last the rest of your life? Moreover, do you have the self-discipline to manage this money, or will you end up using it to buy a new car, go on vacations or being overly generous to friends and family? Are you willing to give up the security of regular pension payments for yourself and your spouse in exchange for the greater financial control of the lump sum payment?
"There is no 'one size fits all' rule. For some clients it makes sense to take a lump sum and for others it makes more sense to take monthly payments. Consumers should seek out a fiduciary advisor who can look at the unique needs of the client before making a decision whether to roll [the funds] into an IRA or leave them with the employer," says Shikha Mittra, AIF®, CFP®, CMFC®, CRPS®, PPC®, president of RETIRE SMART Consulting, LLC, Princeton, N.J.
See also Can I take my 401(k) in a lump sum?