A very common question from pension recipients is: “Our employer gives us a choice of either a pension or a lump sum when we retire. What is the better choice for me?”
Your pension may be an annuity purchased from an insurance company by your employer’s retirement trust, it may be funded by the trust, or covered by the government on a pay-as-you-go basis. There are risks with any of these sources. A pension option will always be a little riskier than a lump sum option because you will need to rely on your sponsor to care for your money.
The pension may not continue making payments as large as promised if the trustor or insurer goes out of business. Furthermore, if you are a government employee, the government may reduce your payments if there is a major budget shortfall.
You will want to determine the options for survivor benefits if you have a spouse. The largest monthly benefit will be for no survivor benefit. However, the law requires your spouse to sign a statement agreeing to this. It’s common to have choices of 0%, 50%, 75%, and 100% survivor benefit. The last choice gives the smallest monthly payment.
An additional consideration is whether or not the pension will be inflation-adjusted every year. If it is, the adjustments will likely be based on the Consumer’s Price Index (CPI) – similar to Social Security. However, very few employers offer plans with inflation adjustments (the exceptions are parts of the federal and state governments). For example, if you get a military pension, it will include the inflation adjustment. When pensions are priced, it’s usually with the assumption of an inflation rate under 4%. As a result, you would definitely benefit from a high inflation environment.
Most pensions from private companies are fixed payments, so inflation adjustments aren’t a consideration.
Most pensions and immediate annuities have fixed payments that continue until you or your spouse die.
When you take your pension as monthly payments, the payments end when you die. After that point, there is nothing left for your heirs. So this is in essence a bet between you and the insurer. You hope you will live longer than the average person, but the insurer knows that the majority of people will die before the insurer runs out of money. The insurer may also have some large fees built into the quotes. It’s recommended that you research your employer’s quote with those of other sources.
By far, the greatest problem with a fixed pension is that inflation continues to erode its value. It’s totally possible for a fixed pension plan to lose 30% of its purchasing power in the first ten years.
If your lump sum is coming from an employer savings plan, then you want to make sure that you roll the money over into an IRA already established for this purpose. If you get the money in your own hands, you’ve just withdrawn an amount that is fully taxable. A mutual fund will help you with the paperwork to avoid this problem. If you are under 59 ½, you also are subject to a 10% tax penalty.
If the lump sum is from a severance package, you will pay income tax, Social Security, and Medicare tax on the proceeds. In this case, you will have to do an after-tax analysis of the comparison (using after-tax values of the pension payments. However, for the rest of your life, you will also be paying Social Security and Medicare taxes on each monthly check.
If you take the lump sum from a severance package and then decide to buy an immediate annuity to provide pension payments on your own instead of using the company offer the calculation is more complex than what is shown below. So, you may want to model this option in the NewRetirement Retirement Planner.
If you take the lump sum and invest it wisely you can make withdrawals each year that will increase with inflation. In fact, the required minimum distributions (RMD) from an IRA or 401(k) increase each year as you age to help counteract inflation. Basically, the RMD is last year’s ending balance of your savings, divided by a conservative estimate of your current life-expectancy. You might refer to this figure as conservative because the IRS adds several years to life-expectancy.
There is an underlying assumption in the IRS rules that your investments will have a return on investment that is at least equal to inflation. You should be able to achieve this with conservative investments like Treasury inflation-protected securities (TIPS) that are sold by the federal government. Another option with a slightly lower return is mutual funds. Good investors who augment their investments with low-cost stock index funds may do better than TIPS, but there is no guarantee. In fact, large numbers of investors often have a hard time beating TIPS because they buy securities when their prices have nearly topped out and sell them at lows.
Whether the funds you invest from a lump-sum payment will last as long as you live is dependent both on the securities markets as well as the amount you take out annually. Investments in stocks, bonds or other funds may outperform inflation in terms of asset appreciation, but that doesn’t mean they will offer you a stream of income, and they may create tax complications for you when you sell.
If you have access to the lump sum, you might end up spending it much faster than you intended. If you are planning on taking the lump sum, you might consider putting some of the money into a reserve account to be used on emergencies rather than planning on systematic withdrawals from the entire amount.
If you don’t have any savings outside of the retirement account, you may want to pick the lump sum option because you’ll have years with unexpected events that will need cash in excess of the annual payments. The pension has no fall-back position.
So how do you compare a fixed pension with a payment that is inflation-adjusted?
Below is a rundown of the numbers. You can do this with paper and pencil, or use the NewRetirement Retirement Planner. This award-winning system will do all the math for you and make it easy to go back and forth between different options. It lets you enter pension information of any kind and it gives you a lot of different options.
Since we are talking about retirement plan choices, the taxes for any choice are going to be at ordinary tax rates. (The comparison is more difficult for annuities that you purchase using funds from non-qualified accounts.)
The first number you’ll need is the amount you can draw from your investments. You’ll need to estimate the number of years you have till death, namely your life-expectancy. You can use the IRS tables from Publication 590 that you can find on www.IRS.gov. Or, try a life expectancy calculator.
Divide the amount in your retirement account by this life-expectancy, and you’ll get the annual amount you can spend from the lump sum. Each year your life expectancy goes down a little, so in future years you divide by a slightly smaller life-expectancy which increases the size of the next year’s payments and compensates for inflation.
The second number you’ll need is the annual amount from the pension. To make a fair comparison, use the pension quote based on the 100% survivor payment option multiplied by 12 to get an annual amount.
If it’s in an inflation-adjusted pension, you can use the result directly, but if it’s a fixed pension quote, you’ll have to make the following simple adjustment to the annual amount. Multiply the annual payment by your age at retirement divided by 100. (This is a good approximation to the detailed financial equation adjustment that’s based on expectations of returns, inflation, and life expectancy.)
Now compare the two annual payments. If the payment from the lump sum is significantly better than the annual (adjusted) pension, chose the lump sum if you feel you can manage the investments. If the annual (adjusted) pension number is significantly higher than the payment from the lump sum, that may be the better choice.
Married couples can gain some risk protection from the pension choice if they choose less than 100% benefit for the survivor. (The analysis above would not be a fair comparison if it was made using less than the 100% survivor benefit.) The risk protection could come from putting away some of the additional payment (compared to the 100% survivor option) into a reserve account if other reserves were inadequate.
Nevertheless, if the choice is a fixed pension, retirees should not plan on spending more of the pension than the after-tax amount multiplied by their age at the time divided by 100. The remainder should go into savings to provide for inflation and be drawn down by the cumulative amount saved divided by the current life-expectancy.
While the math is easy, the risks and considerations aren’t exactly straightforward for making the right pension choices.
How to take your pension is a personal decision that should be carefully considered based on your unique circumstances. That being said, there are some situations which make a lump sum the better option:
- You and/or your spouse are not in good health, and you do not expect to live very long.
- You are confident that you can successfully invest the lump sum amount and achieve favorable investment returns over the course of your lifetime. This means that you think you will be able to generate further income that will last the rest of your life.
- You have enough retirement savings that you do not need the pension to feel financially secure.
- You are concerned about the financial security of your pension plan because your company may go bankrupt in the future and your pension plan will be underfunded if it does.
Before making a final decision, consider your anticipated needs and those of your spouse, the present value of your pension, terms of your pension payments, your tolerance for risk, and your investment experience.
If you think that the risks are acceptable for whichever result that the math shows is better, I’d go with the math, but I’d still want some reserves for the unexpected.
Keep trying all options as part of your overall retirement plan until you find your path to a secure future. Use the NewRetirement Planner to make this easy.