Financial Advisor Insights

Should You Take a Pension or a Lump Sum?

Deciding between a lump sum or receiving pension benefits monthly requires careful planning and consideration. Though your personal situation and circumstance will always be the most important factor in any major financial decision, there are several key considerations to keep in mind when deciding how to take your pension.

What happens if you take a pension as a lump sum buyout?

If your pension plan allows a single payment option, you'll have the ability to roll the funds over to an IRA, similar to rolling over an old 401(k) plan. Provided the funds are moving directly from one custodian to another, taking a lump sum pension payment isn't considered a taxable event. 

Once the funds are invested in an IRA, you may begin to withdraw funds without penalty under the regular IRA distribution rules (typically age 59 1/2). Like an IRA, you will also need to begin taking minimum annual distributions (called MRDs or RMDs) starting at age 70 1/2. Withdrawals from a rolled-over pension will be taxed as ordinary income, which is the same tax treatment as monthly pension income. 

As is standard with an IRA, you can name your own beneficiaries and direct the investment of the account. The funds will grow tax-deferred until they're withdrawn. 

Should you take a lump sum or lifetime pension payments?

One of the most important decisions investors with pension benefits will face is whether to take a lump sum or annuitize the pension into monthly benefits. As you weigh the pros and cons, there are a number of interrelated factors to consider to help guide your decision.  

Do you have other retirement savings?

If you have sufficient assets outside of the pension plan to fund your retirement, (e.g. an IRA, 401(k), 403(b), or non-retirement investment portfolio), you likely don't need to rely on the guaranteed monthly payment from a pension to meet your income needs.

If you haven't saved enough for retirement and are concerned about a shortfall or outliving your savings, then the income from a pension plan may be essential. In this situation, the potential upside of taking a lump sum and investing the proceeds for a higher return is likely not worth the risk, especially since you'd be making withdrawals to cover expenses, leaving fewer dollars invested. For individuals with modest savings, it's often more about steady income to meet expenses than anything else. 

Another consideration: your expected Social Security benefits.

Do the payout options suit your needs?

Depending on your health, family situation, and payment options in your pension, annuitizing the benefits or taking a lump sum could be advantageous. If you're married and in poor health, it may make sense to consider a 75% or even 100% joint and survivor annuity in this case. Keep in mind, there is a reduction of your monthly benefit with this option.

If you don't expect either you or your spouse to have a long life expectancy due to illness, remember, once you elect a joint and survivor annuity, you can't change it after payments begin. Other considerations: up-front access to the funds to cover medical expenses, an assisted living facility, or how either choice may impact Medicare eligibility. 

If you're widowed or unmarried, it may be worthwhile to consider a lump sum or period certain payment, if available. This would guarantee payments to you or your beneficiary for a period of time, perhaps 10, 15, or 20 years. A lump sum could provide additional funds to leave for heirs, provided you're not overly concerned about running out of money during your lifetime. Otherwise, a single life annuity would only pay benefits during your life. Generally, joint and survivor annuities are only available to spouses. 

You'll want to review the payment options in the plan as every plan is different and the reduction of benefits from the single life payment option will also vary. If you and your spouse have a large age gap, the benefit payment could be significantly reduced for joint and survivor payouts as payments would be required over your spouse's much longer life span.

If the options are inflexible or incongruent with your needs, taking a lump sum could emerge as the best option, bearing in mind all of these risks. 

Life expectancy

The longer you live, the more valuable a guaranteed income stream can be. However, many private pension plans don't offer a cost of living adjustment (COLA) which increases pension benefits to keep up with inflation. Without a COLA, over decades in retirement your purchasing power will decline. If you don't have other assets to bridge the gap, it could be problematic. 

Taking a pension as a lump sum allows you to invest in the stock market. Historically, exposure to growth in equity markets has been essential to keep pace with inflation. While the stock market can help preserve purchasing power over time, taking a pension buyout shifts the investment risk from your employer to you. A prolonged downturn or misappropriated investments could mean outliving your assets.    

How aggressive are you as an investor

One of the reasons to consider taking a lump sum instead of receiving pension benefits over time is the goal of outperforming the pension payments by investing the funds yourself. While possible, this shifts the investment risk from the defined benefit pension plan to you: the upside and the downside. Since pensions are designed to be conservative, it's possible to outperform by taking a lump sum, provided you're comfortable with the volatility assumptions. Asset class diversification can help reduce risk, but never to zero.

For conservative investors who prefer a portfolio with a significant amount of bonds, it may not be possible to "beat" the pension on your own. Many retirees seek to reduce their risk to manage market volatility. While taking a lump sum does mean more control to decide how you're invested and who the beneficiary is (particularly for non-spouse heirs), you must weigh whether it's worth losing the promise of income for your entire life. 

Financial stability of your former employer

Although a pension is the best example of a sure thing, there's still no such thing as a sure thing. As it is not 100% possible to say for certain that your promised benefits will continue in their current form, even after you have retired and begun to receive benefits, the financial stability of your employer must be considered. 

Changes to your pension benefits can happen due to many different reasons: bankruptcy, cutbacks, mergers/acquisitions, under-funding, and so on. Depending on why your benefits are being cut, your age, etc, you may still be eligible to receive some benefits thanks to the Pension Benefit Guaranty Corporation (PBGC), a federal agency. 

The PBGC doesn't insure small professional service pensions or non-private plans. Benefits are limited to a maximum guarantee. If you have serious concerns about the viability of the company, it may make sense to consider a lump sum payment if offered.

These considerations also apply when a company seeks to buy out a pension from current and former employees, by offering a one-time payment in lieu of monthly pension income.

Simplified example: lump sum vs pension

To illustrate the risk-reward, consider this overly-simplified hypothetical example.

Jim and Pam are both 70 years old. Jim is already retired and Pam is retiring next week. Pam has the following options:

  • Take a $150,000 lump sum and roll the funds over to an IRA
  • Receive a monthly pension payment of $1,500 for Pam's life, with a 50% joint and survivor annuity, meaning Jim would receive $750/month if he survived Pam

Pam will either need to begin receiving her pension in the current year or begin required minimum distributions (RMDs) as she'll turn age 70 1/2 this year. 

Pension: If Pam lives for 20 years of payments (through age 89), she will have received $360,000 in pension benefits, assuming no cost of living adjustment.

Lump sum: If Pam takes a lump sum and begins RMDs, after 20 years the total of the RMDs she received and her final account value at death would equal $362,900, assuming an annualized return of 6.5%. In another words, she'd need to earn at least 6.5% annually being invested in the market for this strategy to pay off. 

Alternate scenarios:

  • If Pam died after 10 years, and only Jim lived to receive 20 years of pension payments, combined they would have received $270,000, almost $93,000 less than the assumptions for the lump sum scenario above
  • If Jim predeceased Pam, and she dies after 10 years, the couple would only receive half of what they would have if they took a lump sum instead, under the example above
  • Had Pam lived through age 94, her pension benefits would exceed the lump sum assumptions by $40,000. This gap widens to $130,000 if Pam's average investment return dips to 5% (which still implies a decent equity exposure)
  • If Pam wanted to withdraw an amount from her lump sum equal to what she would have received in a pension, $18,000 per year, she would deplete her account during the 12th year (age 81), assuming a 6.5% annual return

Closing thoughts

Determining the optimal strategy for your pension requires an in-depth analysis of your entire financial situation, ideally with the help of a fee-only financial advisor. There are so many nuances to a person's circumstances that can dramatically alter a recommended course of action, so it's really important to engage a professional to help ensure you're taking all of the relevant factors into account. 

Wealth Management Financial Planning Advisor

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