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If you are fortunate enough to be covered by a pension plan at work, then you will have an important decision to make when you retire or leave the company. The balance of your pension plan can be paid to you in monthly payments or all at once as a lump sum. Pension payments are paid to you for the rest of your life, regardless of how long you live. A lump-sum distribution is a large, one-time payment. Generally, that payment is rolled into an individual retirement account, or IRA. Then, the payment can be spent or invested as desired. The pension payments create guaranteed and predictable income for life, while a lump sum gives you greater flexibility and control.
So, should you take the traditional pension payments or elect for a lump-sum distribution instead? The short answer is, there is no short answer. Like many aspects of personal finance, the answer is unique to each person’s situation and needs. It depends on what you would like to do with your money and which risks concern you most.
In my opinion, the emotional aspects of the decision are just as important, if not more important, than the mathematical. Some people feel more comfortable knowing that they will have a steady income for the rest of their lives. Others prefer to control the amount and timing of their income. Even if the math suggests that one option is “best,” the option that reduces stress while still accomplishing your goals is what is best for you. Before you make this decision, there are potential risks that you should evaluate and questions to consider: Would you like to leave money to your spouse, children or a charity? How will your income keep up with inflation? Could you outlive your money if you spend too much or your investments lose money? Can your employer afford the pension payments for decades to come?
If you elect to take a pension payment, you will also have to decide how you want the pension to be paid. There are typically three payment options: single-life, joint-and-survivor, or period-certain. The single life option will pay you for your lifetime, but when you die the payments stop. It would be unfortunate if you died only one year after you retire, especially if you spouse also depends on your pension income. If you want your spouse to be covered by the payment, you can choose the joint-and-survivor payout. This option reduces your benefit during your lifetime, but it will continue to pay a percentage of your benefits to your beneficiary for the rest of their life. The last option splits the difference. A period-certain payment will pay you a lifetime benefit, but guarantees payments to your beneficiary for a set amount of time, often ten years. Your benefit is still reduced, but not as much as the joint-and-survivor option. For any pension payment option, you are limited in how you can pass assets to your heirs. If you choose to take a lump sum distribution, then your beneficiaries would inherit your IRA after you die. If you have a strong desire to leave money to your children, or even a charity, a lump sum might be the better option.
Inflation is also a big concern, especially considering a thirty- to forty-year retirement. A fixed pension payment may struggle to maintain your lifestyle as the costs of goods and services increase. Some pension plans offer a cost of living adjustment, or COLA, that can reduce the impact of inflation. The lump sum can be rolled over to an IRA and invested in stocks, bonds, ETFs, and mutual funds. As a result, it has a better chance of keeping pace with inflation over time. However, those investments are not without risks of their own.
If you choose a lump sum, you are responsible for managing the investments and the distributions. You have to figure out how much you can take out each month or each year without running out of money. If you spend too much too fast, you could run out of money. Similarly, if your investments don’t perform well, you have to decrease your spending or you may outlive your money. You can manage this risk on your own, or with the help of a trusted financial advisor. If you choose the pension payments, your employer takes on this risk for you. They are responsible for investing the plan assets to support the pension payments. Offloading that risk sounds great, but there are other drawbacks to relying on your employer.
One possible downside is if a company goes bankrupt, then they may not be able to continue to pay retirees. According to JPMorgan, 97% of all pensions are underfunded. Should this concern you? Absolutely, but there are protections in place. Pension benefits (up to a certain amount) are protected by the Pension Benefit Guaranty Corporation. The PBGC is a government entity that employers pay into, similar to insurance, in order to protect pension benefits and the retirees that receive them. Even with these protections, some employers indirectly push participants to choose one option over the other. This can happen for a variety of reasons. For example, an employer may not want the expenses or liability of a pension, so they offer a higher lump sum amount. As a result, most of the employees elect the lump sum option. But, it’s not always the employer’s intent. Payout amounts vary based on current interest rates, life expectancy, your salary, and years of service at the company, among other factors outside of their control.
Lastly, it’s important to note that it’s possible to choose both! You could take part of a lump sum and invest it in an annuity. The annuity would provide lifetime income, similar to the pension payments, while the remainder of the lump sum could be invested in an IRA. Some pension plans even have this strategy built in. It’s called a partial lump-sum option plan, or PLOP. A PLOP allows you to take a portion of your pension as a lump-sum, which you can then invest, while also receiving pension payment, albeit at a reduced benefit.
There are many factors to consider but you may prefer a lump sum if:
You haven’t participated in the pension for long and your balance is a trivial amount
- You have a shortened life expectancy
- You think you can earn a higher rate of return in your investments
- You already have other sources of guaranteed income
- You want to leave assets to spouse, children, grandchildren, or a charity
- You worry about your company’s ability to pay
Similarly, you may prefer a pension payment if:
You expect to live beyond average life expectancy.
- You or your spouse already have substantial retirement assets that are not guaranteed.
- You prefer not to take on the responsibility of managing investments yourself
- You fear you may overspend if given access to all the money at once
- You think investment returns will be lower than expected
- Your company-sponsored health insurance stops if you take a lump sum.
These risks are universal, but how they affect you and your family is very personal. At Swisher Financial Concepts our team focuses on people, not just numbers. We would be happy to help evaluate your options and implement the strategy that works best for you.