You may even be one of the lucky few with an employer who offered a pension. Now it’s time to just sit back and collect monthly payments for the rest of your life. In fact, you think you have your financial picture all sorted out. That is, until you get a letter about your pension, offering you the option to take a lump sum “buyout” in lieu of monthly payments.
Now you start to worry. You have to decide between monthly annuity payments or one (potentially sizeable) check. How do you even make a decision like that? Where should you start?
This can be a tricky situation. That being said, here are a few things you should consider when faced with this particular dilemma.
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First and foremost, it is important to understand exactly what a pension is. Generally speaking, a pension is a series of payments made to a person during their retirement. Payments come from an investment fund into which that person, or his/her employer, has contributed throughout their career.
Other Cash Flow and Income Sources
It might go without saying, but the decision of whether to take a lump sum payout or monthly payments should be influenced quite a bit by your overall financial picture.
If you have other sources of predictable and steady cash flow — such as social security or a working spouse’s salary — coming in each month, you might feel a little more flexibility to take the lump sum. Contrast that with monthly pension payments being your only source of income, and you have quite a different decision to make.
Let’s take a look at some of the reasons you might want to consider taking a lump sum payout, rather than sticking with the monthly annuity.
Get Your Money Right Now
This is probably the biggest enticement for a lump sum payout. With traditional monthly disbursements, you have to wait for the next month before receiving your next payment. While this may seem intuitive, there is a certain restlessness that can come from knowing that you have a relatively large asset that you can only access according to a very strict monthly timeline. For those who have a hard time waiting for things, the lump sum may seem more attractive.
A lump sum payout can also be an opportunity to eliminate debt that might otherwise take longer to pay off. For some people, preparing for retirement is all about reducing your expenses. One way to do that is to weigh the benefits of paying off high interest debt (or debt with large monthly payments) against the prospect of a monthly cash flow.
You Might Be Able to Invest the Money Better
Part of the appeal of a pension is the predictability and stability. As with most financial propositions, less risk means (likely) lower growth. In other words, taking the safe bet generally gives you a lower prize. Such is also the case with pensions.
For example, say you have a pension set to pay you $48,000 per year (around $4000 per month) with the option of taking a lump sum payout of $575,000. In this case, it would take you 12 years of spending down the principal of the lump sum to break even with the lifetime annuity payments.
You may think you can do better than that by investing the lump sum. This is where things can get complicated fast.
One of the main factors here is your life expectancy. As much as we hate to think about our lives in actuarial terms, the facts remain. In the example above, if you choose the monthly annuity payments but live fewer than 12 years, “you lose” in terms of leaving money on the table. Taken the other way, if you live 35 more years, you might very well come out ahead.
Potential Tax Benefits of the Lump Sum
If you take the monthly annuity payment, you will have to pay federal income taxes on that income the year it is received, just as you did with your wages. However, if you choose the lump sum, this is not necessarily the case. This is because there are ways to defer the income tax.
IRS rules allow you (in most cases) to roll the lump sum payout from a pension plan into a traditional IRA. If you go this route, you will only be taxed on the distributions from the IRA as you make them, just as you would with any other IRA distribution. This can be an awesome way to beef up your IRA account, and like mentioned above, this option can give you increased control over the investments you make with your pension funds
Resource: The IRA Investor’s Checklist
Potential to Leave More Money to Your Beneficiaries
The “monthly payments for life” structure of a pension plan is generally considered one of its main advantages. This can, however, be a double-edged sword. The primary purpose of pension plans is to provide a stream of income to a former employee for the rest of their lives as a deferred part of their compensation for the years of work they performed.
That being said, pension plans do not usually provide any considerations for the pensioner’s beneficiaries. There exist some plans allowing for spousal benefits, but they are the exception.
For example, Bill begins collecting his pension at 65. Sadly, he gets hit by a bus the very next month. Bill’s beneficiaries would likely be left with no income or benefits from his pension.
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Conversely, imagine the above scenario began with Bill taking a lump sum pension payout prior to his untimely passing. In this case, the money from Bill’s pension will pass to his beneficiaries in accordance with his estate plan.
By now, you might be thinking that a lump sum payout is definitely the way to go. Here are some not-so-positive things you should keep in mind before you decide:
Due to the way lump sum payouts are calculated, choosing this option will mean getting less money from the pension plan overall. Generally speaking, this is because pensions are similar to other lump sum payouts, such as legal settlements or sales of an annuity contract. As such, they base the payout amount on the “present value” of the future payments.
Investopedia has defined present value as “the current worth of a future sum of money or stream of cash flows given a specified rate of return.” Due to the effects of inflation, and other factors, the present value is always lower. This is why is it also known as the “discount rate.”
Possibility of Mismanagement
Sure, having total control of how your pension funds are invested can lead to higher potential returns. But, it can also lead to much much lower returns or even a total loss of your funds.
Part of the trade off for the relatively low internal rate of return within most pension plans, is the safety and security of getting those monthly payments. By taking the lump sum to invest yourself (or spend it all), you run the risk of not being able to count on cash flow from that pension.
This is one of the reasons it is important to take your whole financial picture into consideration. There are those who cannot risk missing out on a stable source of income. For them, taking the cash and investing it on their own may not be the smartest option.
There is No One “Right Answer”
At the end of the day, there is no perfect answer that will work for every situation. As with most things in personal finance, deciding whether to take a lump sum pension buyout is a personal decision that requires looking at your particular circumstances.
Pension buyouts can be very sizeable amounts, and have the possibility to be the largest check (or wire transfer) you will ever receive. The prospect of such getting a payday can feel like a windfall. Like “free” or “found” money. This is why it’s a good idea to seek the advice of your tax or financial advisor and to take your time making such a decision.