I can offer one piece of advice on making a decision between taking a monthly pension vs. a lump sum; don’t listen to your financial advisor! There may be nobody who benefits more from you deciding to take the lump sum than your financial advisor. And guess what, your financial advisor will almost always suggest a lump sum. Is this because your advisor has looked deeply into your personal situation and determined that you are better off financially with a lump sum? No, it’s because your advisor has looked at his commission schedule and realized that he is better off if you take the lump sum! Now, there are many people that probably are better off taking the lump sum, but remember to be weary of from whom you are getting the advice. At the end of the day, you need to be the one that is comfortable with the decision you choose. This article will help you decide if the monthly pension or lump sum is a better option for you.
First, we need to discuss some pension basics. You typically have two options once you leave your employer in regards to taking your pension; take it immediately or postpone it until a later date. If you are leaving your employer but going somewhere else to work, you may decide to postpone your pension. If you do take the lump-sum option, you should have the option to roll it into your 401(k) or IRA which allows the money to grow tax-deferred until you actually start taking distributions. The tax liability on pension distributions and lump-sum distributions should be about the same as long as the yearly distributions are the same. The more you receive, the more you pay in taxes, just like your job prior to retirement. The lump-sum calculation is not random, and your company will not try to ‘lowball’ you as I hear some clients complain. Lump-sum calculations are based on your monthly pension benefit, your life expectancy, and current interest rates which are published by the IRS each month. The lower the interest rates, the higher your benefit. Typically, lump-sum figures are recalculated each year with updated interest rates used to determine the figure, which can cause large swings in your benefit. For example, the General Motors lump sum amount is recalculated each September, based on interest rates from July.
So, which one is better for you? First, let’s talk about the pros and cons of both options.
- More control; both over your investments and your withdrawals
- Can keep up with inflation better than a monthly pension
- Can be passed on to your heirs if you don’t spend it all
- You could withdraw it all, leaving you with nothing before you die
- You may be afraid to withdraw anything, worried you may exhaust it quickly (read more about this issue here)
- You have to be comfortable managing (or having someone else manage) the money
- Consistent monthly payments that you can rely on
- You don’t have to worry about investing the money
- Won’t run out before you pass away
- Inflation eats away at the purchasing power (unless COLA adjusted)
- No flexibility in withdrawals or tax planning
- Reliance on company to pay your benefit
- Not passed on to heirs when you die
The lump sum pension option biggest advantage, its flexibility, can also end up being its biggest disadvantage. You control the investments and the withdrawals which can lead to bigger gains and potentially larger distributions than a monthly fixed pension. It can also lead people to exhaust everything quickly and unfortunately, I’ve seen this before. A client takes the lump-sum and feels like it will last forever. The family pays off their mortgage, a few credit cards, and buys a new car. They give some to the kids and before they know they have exhausted just about everything and relying solely on Social Security. Obviously, this is worst case scenario but there is another problem that people struggle with the lump sum, investing the money.
For many people the lump sum represents a significant portion of their wealth, and this money now has to be invested. A person that takes the lump sum needs to be comfortable with this amount of money being invested and going up and down with market fluctuations. For example, let’s say a couple has saved $500,000 and then they take a $500,000 lump sum pension and now they have a retirement savings of $1 million. If this money is invested, a 10% drop in the stock market (which typically happens every 18 months or so) would mean a roughly $100,000 drop in your investments. For many people that is more money than they were making before retirement in a year, and now it is gone just like that! You have to be comfortable with larger fluctuations in your investments because the lump sum payment typically increases your investments significantly. To combat these fluctuations, a person may invest the money too conservatively and earn a rate of return lower than what is required for the person to justify taking the lump sum. Typically, a person needs to earn over 4 or 5% per year on the lump sum in order for them to make more on the lump sum compared to the monthly pension.
I work with a lot of people and I run many financial plans comparing what their retirement plan looks like with both the lump sum and the monthly pension. And that is fine, but the decision to take the lump sum vs. the monthly pension is so much more than just which looks better on a financial model. Overall, you should choose the option which you feel more comfortable. What I usually find is that your first impression is probably the best option. I’ve laid out a few scenarios below which may lead you one way or the other, but ultimately do what you feel better about.
When to take the lump sum
You don’t need the money immediately. If you are leaving an employer and not retiring but rather working somewhere else. Or, maybe you have a spouse who is still working so you don’t need the pension money yet. If your time frame is at least 5 years until pension distributions, you may be better taking the lump sum and investing the money until you need it.
You are in poor health, or have a family history of short life expectancies. No one knows when they will pass, but if you do pass early, the lump sum allows you to pass more to your heirs.
A spouse is already collecting a monthly pension. This allows you to diversify your investments and retirement strategies.
Your company is in bad financial health. You may prefer to control the money as opposed to relying on your employer to pay you for the rest of your life.
Reasons to take the monthly annuity
You are a very conservative investor. The monthly annuity doesn’t require you to invest the money, instead you can rely on a steady stream of income.
Your lump sum is larger than your current investable assets. As I mentioned before, when the lump sum is large compared to your current investable assets you may struggle with investing this amount of money and the fluctuations that come with that much invested.
You aren’t great at budgeting. Be honest here, can you really create and follow a budget? Many people don’t follow a budget while working, rather just spend the money that they have left over each month. This can be very problematic with the lump sum, because you may exhaust all of it too quickly. A monthly pension forces you to budget.
One thing I hear consistently is that a client will prefer to take the lump sum because they are nervous that their employer won’t be able to pay them for the next 30 years. This is understandable being that here in Michigan auto companies and auto suppliers, have had their share of financial issues in the past. This is a real concern, but it is important that if you work for a company that is not a municipality, your pension should be protected. The Pension Benefit Guaranty Corporation (PBGC) is a government agency that essentially works as an insurance company for pension plans. The PBGC will pay your pension if your company files for bankruptcy and is unable to meet its pension obligation. The amount that you are “insured” depends on your age. The older you are when your company goes bankrupt the higher that you are guaranteed. In 2018, a 55 year old is protected up to $2,195 per month for a 50% joint and survivor benefit pension. This means that if you are 55 in 2018, and your company goes bankrupt and you choose the 50% joint and survivor benefit (spouse gets 50% of your benefit when you pass for the rest of her life) the PBGC will cover up to $2,195 per month of your monthly pension. This may not seem like a huge amount of coverage but at age 65 this coverage jumps up to $4,878 per month. Important to remember that states, cities, and municipal workers are not protected by the PBGC and therefore may have a bigger incentive to take the lump sum if offered.
One last suggestion in regards to making this very important decision. Don’t ask friends who have already made this decision for their recommendation. Your friend will almost always tell you that they made the right decision, even if they may be regretting it. No one wants to admit that they made a mistake in one of their largest financial decisions ever! Also, maybe your friend took the lump sum during this raging bull market. Sure, they may be thrilled with their investment currently, but we’ll see how comfortable they are when the market takes a big drop. Everyone is different, and even if the decision they did make works for them, it may not work for you. The monthly pension vs. lump sum is extremely personal and unlike other financial planning concerns, it needs to be more than just a numbers decision, but rather a comfort decision.