Lump Sum or Monthly Pension?

Peter A. ScilovatiApril 2, 2015

Wealth Preservation & Distribution

Many of our clients are faced with the decision of turning on their monthly pension from an employer’s defined benefit retirement plan or accepting a lump sum offer from the employer.

Faced with mounting pension costs and greater volatility, companies are increasingly offering their current and former employees a critical choice: Take a lump sum now or hold on to their pension. Pension buyouts can be offered to any current or former employee of a firm. You may be already receiving benefits as a retiree with an accrued (vested) benefit, or you may have a vested benefit from a former employer, or your current company may be offering you a pension lump sum buyout long before you retire.

Whatever the case, here’s how a pension lump sum offer typically works: Your employer issues a notice that by a certain date, eligible employees must decide whether to exchange a monthly benefit payment in the future for a one-time lump sum. If you opt for the lump sum, you’ll receive a check from the company’s pension fund for that amount, and the company’s pension (or defined benefit) obligation to you will end. Alternatively, if you opt to keep your monthly benefits, nothing will change, except the option to take a lump sum will be removed.

The process is relatively simple, but the decision about which option to take can be complex. Here are the pros and cons of each option:

Keeping the monthly payment

Pension plans typically provide a payment of a set amount every month from your retirement date through the rest of your life. You may also choose to receive lifetime payments that continue to your spouse after you die.

These monthly payments do have drawbacks, however:

  • If you’re not working for the company making the offer, your benefit amount typically will not increase between now and your retirement date. During retirement, your life annuity payments typically do not come with inflation protection, so your monthly benefits are likely to lose purchasing power over time. An annual inflation rate of 3%, the average since 1926, will cut the value of your benefit in half in 24 years.
  • Taking your pension benefit as a life annuity means you may not have access to enough money to fund a large, unexpected expense.
  • Your ability to collect your payments depends in part on your company’s ability to make them. If your company retains the pension and can’t make the payments, a federal agency called the Pension Benefit Guaranty Corporation (PBGC) will pay a portion of them up to a legally defined limit. The maximum benefit guaranteed by the PBGC in 2014 was $4,943 per month for most people retiring at age 65.

Taking the lump sum

A lump sum may seem attractive: You give up the right to receive future monthly benefit payments in exchange for a large cash payment now—typically, the actuarial net present value of your age-65 benefit, discounted to today. Taking the money up front gives you flexibility: You can invest it yourself, and if you have assets remaining at your death, you can leave them to your heirs.

However, keep in mind the following factors:

  • You are responsible for making the funds last throughout your retirement.
  • Your investments may be subject to market fluctuation, which could increase or reduce the value of your assets and the income you can generate from them.
  • If you don’t roll the proceeds directly into an IRA or an employer-qualified plan such as a 401(k) or a 403(b), the distribution will be taxed as ordinary income and may push you into a higher tax bracket. If you take the distribution before age 59-½, you may also owe a 10% early withdrawal tax penalty.

Making your choice

Whether it’s best to take a lump sum or keep your pension depends on your personal circumstances. You’ll need to assess a number of factors, including those mentioned above and the following:

  • Your retirement income and essential expenses. Guaranteed income, like Social Security, a pension, and fixed annuities, simply means something you can count on every month or year and that doesn’t vary with market and investment returns. If your guaranteed retirement income (including your income from the pension plan) and your essential expenses, such as food, housing, and health insurance, are roughly equivalent, the best choice may be to keep the monthly payments, because they play a critical role in meeting your essential retirement income needs. If your guaranteed income exceeds your essential expenses, you might consider taking the lump sum: You can use a portion of it to cover your monthly expenses, and invest the rest for growth.
  • Longevity. Both your monthly benefit’s payment and the lump sum amount were calculated using actuarial calculations that take into account your current age, mortality tables, and interest rates set forth by the IRS. But these estimates don’t take into account your personal health history or the longevity of your parents, grandparents, or siblings. If you expect to have an above-average life span, you may want the predictability of regular payments. Having a payment stream that is guaranteed to last throughout your lifetime can be comforting. However, if you expect to have a shorter-than-average life span because of personal reasons or your family medical history, the lump sum could be more beneficial.
  • Wealth transfer plans. After you’ve considered retirement income and expenses (no comma here) and have planned an adequate cushion for inflation, longevity, and investment risk, it’s appropriate to take wealth transfer plans into consideration. With pension plans, you often don’t have the ability to transfer the benefit to children or grandchildren. If wealth transfer is an important factor, a lump sum may be a better option.

Next steps

  • First and foremost, make sure you know whether you have any pension benefit at your current or former employers, and keep your contact information with those companies up to date. You cannot even consider an offer if you don’t know it exists.
  • Second, make sure you have a plan for retirement. If you understand your needs, you will be better prepared to understand which option is right for you if you do receive a lump sum offer. Because these offers usually have a limited window for election, it will be more difficult to make an educated and informed decision without knowing, in advance, your total retirement financial picture.
  • If you decide to take a lump sum in lieu of monthly pension payments, you may want to consider rolling it over to an IRA. A direct rollover from your employer’s plan to your IRA provider (trustee to trustee) will not be subject to immediate taxation and may be the best way to preserve the tax-deferred status of this money.

As always, do not hesitate to contact our office if you have any further questions or if you would like any assistance in making this decision in your situation.  We can help!


*Source: Fidelity Brokerage Services