Should You Take Pension Payments or a Lump Sum Payout?
If you are lucky enough to have a pension waiting for you at retirement - count your blessings. That being said, when it comes time to retire you will have to decide between accepting a lump sum buyout or opting for pension payments. In this blog post, we will explore the differences between these two options, their pros and cons, and the factors you should consider before making your choice. The choice is a permanent one - so go about it cautiously and make sure you have a clear understanding before putting pen to paper.
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Executive Summary
Compare pension payments and lump-sum distributions to determine the best retirement option.
Consider life expectancy, financial goals, and impact on spouse/beneficiaries when making a decision.
Seek professional advice from a qualified fiduciary financial advisor to make an informed decision.
Table of Contents
Understanding Pension Payments and Lump Sum Options
Monthly Pension Benefits
Lump Sum Payment
How to Compare Pension Payments Against A Lump Sum Distribution
The Numbers
Pros and Cons of Pension Payments vs. Lump Sum
Factors to Consider When Choosing Between Pension Payments and Lump Sum
Seeking Professional Advice
Frequently Asked Questions
Understanding Pension Payments and Lump Sum Options
When it comes to pension payments, there are two primary options: lifetime monthly payments or lump-sum distributions. Lifetime monthly payments provide a guaranteed income throughout your retirement, whereas lump-sum distributions give you a one-time payment to manage as you see fit.
Monthly Pension Benefits
Employers will each have their own unique formula for calculating the monthly pension amount. Generally, the monthly pension is calculated based on years of service, final average salary, and a benefit multiplier (usually something like 1%).
For example: Assume you have 30 years of service, your final 3 years average salary is $136,000, with a benefit multiplier of 1%. Your formular would look like: 30 x 136,000 x .01 = $40,800. This is an annual amount, so we would divide $40,800 by 12 and arrive at a monthly pension benefit of $3,400.
This type of pension payment provides a steady, predictable income allowing you to reliably estimate your cash flow - at least from that source. The complexity of this method arises in selecting the proper monthly pension benefit. You will be presented with a menu of benefit options to choose from, the most common of which are: "single life annuity", "joint and survivor benefit", or "period certain".
The joint and survivor benefit allows two beneficiaries (typically the pension holder and their spouse) to receive a reduced monthly benefit. Upon the pension holder’s death, the spouse will be eligible to receive a survivor benefit. When selecting the joint and survivor option, you may be offered survivor benefits that range from 50% to 75% of the original benefit amount. The higher the survivor benefit you elect, the lower the primary benefit amount will be. Essentially you are giving up present day income in return for a higher predictable income for your surviving spouse.
The single life annuity can only be opted into by individuals or married persons whose partner signs a release acknowledging them giving up their right to a survivor benefit. The single life annuity will pay more than a joint survivor benefit due to the fact that the pension plan only needs to guarantee one life rather than 2.
The "period certain" benefit option guarantees a benefit payment in the event of early death of the pension holder. For example, say the pension holder opts for a single life annuity with 10 years period certain. Without the period certain option, if the pension holder were to pass 3 years after beginning benefits, the benefits would end and there would be no additional money paid to heirs. But with the 10 year period certain option, a beneficiary chosen by the original pension holder would receive another 7 years of payments until the 10 year guarantee period were completed. Just as with the joint survivor benefit, opting for a period certain benefit will reduce the monthly payment amount.
An additional important takeaway here is that regardless which monthly benefit option you select, you - the pension holder - don’t have to worry about investment responsibilities, as the pension plan takes care of that for you.
Are you looking for a Fee Only Fiduciary Certified Financial Planner Professional to help you evaluate your pension payout decision? Click here to schedule a free no obligation consultation.
Lump Sum Payment
Pensions are expensive to maintain. They continue to cost more to the employer and produce worse investment results over time.
Lump-sum distributions are one-time payments made by a pension administrator.
Often times your company will want you to take the pension buy out, reducing their risk that you will live a long life and that they will need to meet an expensive income obligation to you.
With a lump sum distribution, you can take the pension tax free and roll it over into an individual retirement account (IRA).
Once rolled into the IRA, you get to decide how you want to invest or spend the money, giving you greater control over your retirement funds.
Before accepting any lump sum buyout offer, it’s essential to verify the accuracy of your pension statement information. Consult a fiduciary financial adviser to run the numbers and ensure you make the right decision.
Are you looking for a Fee Only Fiduciary Certified Financial Planner Professional to help you evaluate your pension payout decision? Click here to schedule a free no obligation consultation.
How to Compare Pension Payments Against A Lump Sum Distribution
Comparing regular pension payments vs a lump-sum distribution involves analyzing the numbers. We need to identify the investment returns offered by the pension plan to know what rate of return we would need to beat in order to make the lump sum distribution worth it.
It's helpful to begin by understanding some rules of thumb.
1) The longer you live, the greater the return your pension will deliver, and thus the higher return you would need to achieve on your own using the lump sum. This means that opting for lifetime income payments becomes more lucrative if you expect to live longer (ie: parents lived longer then average, you are in good health, etc.).
2) The higher interest rates are when you retire, the lower your pension lump sum offer will be. This means it will be less competitive to take lump sum distributions when interest rates are high, and more lucrative to take the distribution when interest rates are low (This does not mean it's never right to take the lump sum when rates are higher - it just requires greater consideration).
The Numbers
Say you are offered a $500,000 lump sum buyout. The single life annuity option offers you $25,000 per year, or $2,083 per month. Let's compare the two options.
The first step is to identify how long the income payments would take to pay back the full lump sum amount. In this case $500,000 divided by $25,000 per year results in a pay back period of 20 years. That's a long time to wait for the repayment of principal...
That $25,000 annual benefit is the equivalent of achieving a 5% annual rate of return on the $500,000 distribution. The question arises - do you think you could outperform that 5%? Can it be done without taking on a disproportionate amount of risk?
Note: Don't forget to consider the income tax implications of both options. Most pensions are taxed at ordinary income tax rates. The same goes for funds in Individual Retirement Accounts.
The next thing to consider is the fact that the pension payment will, in most cases, not be inflation adjusted. That $25,000 annual income stream becomes less and less valuable in terms of purchasing power for each additional year you live. The benefit amount will most likely be frozen, meaning there is nothing you can do to influence the income stream - you're stuck with $25,000 per year for life. This leads to the next question - is it possible to outpace inflation if you were to take the lump sum?
In most cases that I review, I'd rather take the lump sum and invest in a diversified portfolio.
But many conservative retirees may opt for the guaranteed 5%. It's predictable, stable, and they do not have to get their hands dirty investing it themselves (or working with an investment advisor to do it for them).
Again, we recommend consulting with a fee only fiduciary financial advisor to help you analyze these factors and make the right choice.
Are you looking for a Fee Only Fiduciary Certified Financial Planner Professional to help you evaluate your pension payout decision? Click here to schedule a free no obligation consultation.
Tradeoffs of Lifetime Payments versus Lump Sum Distributions
This decision is not only about the numbers. Now we need to analyze the quality-of-life tradeoffs of selecting an income stream versus a lump-sum distribution.
Disadvantages of Electing for Lifetime Payments
Loss of purchasing power
We addressed this above - but it is important to note whether your pension will be inflation adjusted or not. In most cases if the pension is not through a government or municipal agency, the monthly benefit amount will not be inflation adjusted. This results in a loss of purchasing power over time that you cannot influence. Your only recourse is to have assets in other investments that can make up for the loss in purchasing power.
With a lump sum option rolled into an IRA, you can construct, monitor, and adjust an investment portfolio that will address this loss of purchasing power.
Lack of access to principal
When you commit to taking an income stream from your pension, you give up your right to the principal. In plain English - you cannot access the money within the pension. All you get are the monthly checks. You have no control over distribution frequency, taking amounts out for emergencies, or using the funds for purchases.
When you take a lump sum and roll it into an IRA, you have control over how often and how much you want to distribute, access to the funds for emergencies or personal goals.
Lack of inheritance
Also critically important to consider is the fact that when opting into an income stream (monthly payments), your heirs will receive nothing from that pension, as the income stops when the owner (or spouse) passes.
With a lump sum distribution rolled into an IRA, your children and heirs will be able to inherit the remaining balance of the account.
A permanent decision
The last thing to remember is that whichever course you choose, the decision is permanent. There are no do overs. For that reason, begin your research early. Do not wait until the last minute when you will feel pressured to make a decision, potentially without all the information you might need. Due to the level of consequence of this type of decision, we always recommend working with a fiduciary financial adviser to evaluate your options.
Are you looking for a Fee Only Fiduciary Certified Financial Planner Professional to help you evaluate your pension payout decision? Click here to schedule a free no obligation consultation.
Disadvantages of Lump Sum Distributions
Lump-sum distributions come with their own set of drawbacks. One significant risk is the potential to run out of money without careful asset management.
Another potential disadvantage of lump-sum distributions is the loss of company-sponsored health insurance coverage. In some cases, employers will allow you access to "retiree benefits packages" that include continuation of certain types of employee coverage, the cost of which will be deducted directly from your pension income. If you opt for a lump-sum distribution, you may lose access to this valuable benefit.
Given the potential ripple effects, consult with a fiduciary financial advisor before making a commitment.
Are you looking for a Fee Only Fiduciary Certified Financial Planner Professional to help you evaluate your pension payout decision? Click here to schedule a free no obligation consultation.
Additional Factors to Consider
Life Expectancy and Health
Repeating what was written above: the longer you live, the greater the return your pension will deliver, and thus the higher return you would need to achieve on your own using the lump sum. This means that opting for lifetime income payments becomes more lucrative if you expect to live longer (ie: parents lived longer then average, you are in good health, etc.).
Financial Goals and Needs
Liquidity, or access to your funds, is a critical component of navigating retirement successfully. You are not only choosing between a steady income or a lump sum payment. You are also choosing whether to give up access to a large portion of your retirement savings in exchange for delegating the responsibility for managing that money to the pension plan. If you choose the pension income option over the lump sum, it's important that you feel confident that the pension administrator can support your lifetime retirement income needs. Conversely, if you choose the lump sum option, you must be confident that either you or your financial advisor can support your lifetime income needs!
A Retirement Income Plan will be your best tool to project AND monitor your retirement income needs.
Again, we recommend consulting with a fee only fiduciary financial advisor.
Impact on Spouse and Beneficiaries
The impact on your spouse and beneficiaries is another important factor to consider when choosing between pension payments and lump-sum distributions. If you opt for pension income, your spouse and beneficiaries may not be eligible to receive any of the money in the event of your passing. Conversely, if you choose the lump sum option, your spouse and beneficiaries will be able to receive the remainder of your funds when you pass away.
Seeking Professional Advice
Given the complexity of choosing between pension payments and lump-sum distributions, it’s wise to seek professional advice from a qualified, fee only, fiduciary financial advisor.
Summary
Deciding between pension payments and lump-sum distributions will be one of the most significant decisions of your lifetime. Move slowly, do your research, and seek to understand your options. We've hammered this point home enough, but let's do it one more time. This decision is permanent, so make your choice wisely.
And don’t forget to seek professional advice to ensure you’re making the most of your hard-earned retirement funds.
Frequently Asked Questions
Is it better to take pension annuity or lump sum?
It is generally better to take a lump sum distribution if you are concerned about the solvency of your pension provider, if you are concerned about liquidity, or if your pension does not offer a cost of living adjustment. For the more conservative investor who may have significant assets outside of their pension, the pension annuity option may be preferred due to the guaranteed lifetime income it offers.
Ultimately, each person needs to decide what is best for their financial situation.
How do I avoid taxes on lump sum pension payout?
Investors can avoid taxes on a lump sum pension payout by taking advantage of the rollover option and transferring their funds into an IRA or other eligible retirement account. Doing so allows individuals to postpone taxation until withdrawals are made, potentially saving money in the long run.
What are the primary differences between pension payments and lump-sum distributions?
Pension payments provide a steady and reliable income over time, while lump-sum distributions offer a one-time payment that can be used for more immediate financial needs. Retirement benefits through pensions are paid out regularly over time, while a lump-sum distribution allows access to a larger sum of money right away. With pensions, beneficiaries have the security of consistent retirement income, but with lump-sum distributions, they can spend or invest the money as they see fit.
Other Financial Planning Resources:
A Guide to Financial Planning Costs
What is a Flat Fee Financial Advisor?
What are Sequence of Returns Risk and the Retirement Risk Zone?
If you found the information above helpful, click here to watch my free Masterclass training that explains how you can increase your income in retirement by up to 30% and avoid running out of money in retirement.
