According to the U.S. Department of Labor, the 1970s saw private pension plans to the tune of 103,000. By 2017, that number had dropped to 46,700. Recently, the Bureau of Labor Statistics reported that only 17% of private-sector workers enjoy access to a pension.
This downward trend toward extinction is set to continue. Not only are defined-contribution plans—such as 401(k)s—less expensive and less complex to manage than private pension plans, but employers also want to mitigate future pension obligations (thus reducing corresponding impacts on their financials). This is especially true for industries that watched the COVID-19 pandemic wreak havoc on their financials. To reduce future pension obligations, companies often offer participants a lump sum payment option in lieu of future monthly payments.
The stability of monthly payments may sound reassuring, while the lump sum offer is perhaps irresistible. So, how can you decide? Quite frankly, this is a significant decision and one not to be taken lightly. This post serves to provide some education on various options available, making your life a little bit easier in the process.
When a lump sum payout may make sense
You might make more money investing on your own
If you’re comfortable investing on your own (or with the help of an advisor) and feel confident you can earn higher returns on your investment, a lump sum offer could make the most sense. The question really boils down to how much you would need to earn on your investment in order to make more than the value of your monthly pension.
To determine this number, consider the 6% rule: which states that if your monthly pension offer is 6% or more of the lump sum offer, you should choose the perpetual monthly payment option. If the number falls below 6%, you might do as well (or better) by taking the lump sum and investing it yourself.
To illustrate, let’s assume you need to choose between a monthly pension of $1,000 (beginning at age 65) or a lump sum offer of $160,000. If you annualize the monthly payment ($12,000) and divide it by $160,000, you get 7.5%—which is the return you’d need to earn every year (on your lump sum payment) to match the value of the monthly payment offer. As S&P returns averaged under 7% from 2000-2021, earning an annual average of 7.5% is perhaps a daunting task.
Additional factors to consider with this option include your projected longevity (while this is of course difficult to predict, it’s important to remember that the value of your monthly pension will grow as you age), the age at which you claim benefits, as well as any provisions in your plan that also pay beneficiaries (such as a spouse).
You don’t need the money
If you’re fortunate enough to enjoy sufficient sources of retirement income and are confident you won’t require monthly payments, accepting a lump sum offer is perhaps the best option—giving you the freedom to do whatever you want with the money. Moreover, if the lump sum payment option can also help you delay claiming Social Security, this will actually increase your monthly benefits because SS benefits increase by approximately 7% each year between age 62 (the year you’re first eligible) and your full retirement age (age 67, if you were born after 1960). After that, the increase rises to approximately 8% each year between your full retirement age and age 70.
You want to protect your legacy
With a lump sum payment, you can leave any assets remaining at the time of your death to your children or other heirs. In contrast, a monthly pension ceases when you or a spouse dies (depending on your plan options—more on this later), meaning you won’t be able to leave anything for your heirs.
You’re in poor health
As a general rule, people in good health or with good reason to believe they or a spouse will live beyond the average life expectancy may consider monthly payments the more attractive option. If you’re in poor health, don’t expect to live very long, and don’t need to worry about your spouse’s financial situation, a lump sum payment may make the most sense.
You are worried about your employer’s financial situation
The truth is that even if your employer goes bankrupt, this likely won’t impact you much because the Pension Benefit Guaranty Corporation (PBGC)—a federal agency created to protect most private-sector pension plans—would likely replace your payments in full up to specific age-based limits. For example, their most recent guarantee for someone aged 65 is a maximum of $6,034.09 per month. The median private pension benefit for those aged 65+ is just under $10,000 a year.
If you have a public pension, you can also rest easy. Every state guarantees some form of legal protection for public retirement benefits, and states also have the ability to raise taxes to make up for any pension funding deficits.
If your pension lies with a religious institution, then there could be a reason to worry because such pensions aren’t usually covered by the Pension Benefit Guaranty Corporation.
Finally, the PBGC also doesn’t typically cover professional service employers (such as doctors and lawyers) who haven’t had more than 25 active participants since the ERISA enactment date.
When a lump sum payout may NOT make sense
Why wouldn’t you take a lump sum offer? Here are a few reasons why:
You’re worried about outliving your retirement savings
Retirement accounts such as 401(k)s fluctuate in value, meaning the amount available to you will vary. This can make it more challenging to plan for expenses, especially essential costs such as those for housing and healthcare. Alternatively, a pension is guaranteed income; you can count on the same amount every month for the rest of your life. Although most pensions don’t adjust for inflation, monthly payments can give you additional peace of mind.
You’re a spender
If you’re not disciplined, enjoying easy access to a large sum of money is often almost impossible not to tap into. Want to take a much-needed vacation? Pay for some house repairs or help your kids purchase their first home? Do it, and you’ll likely shortchange your retirement. Don’t just take our word for it! A recent MetLife study claimed that 1 in 5 people who took a lump sum offer depleted their money within five and a half years. An additional 35% were concerned these funds would run out.
You’re married
Most traditional pensions offer joint and survivor options, allowing for two beneficiaries—often you and your spouse—in exchange for a reduced monthly benefit. In other words, your spouse will continue to collect a pension benefit (typically 50% or more of your benefit) even after your death. When you take into consideration that women live longer than men (an average of 6-8 years, according to the World Health Organization), losing this option can ultimately hurt wives—especially if they’ll need the money.
Other pension considerations
You should know that if you don’t roll over the lump sum directly into an IRA or employer-qualified plan such as a 401(k), the money you’ll receive is taxed as ordinary income. Consequently, you could find yourself in an even higher tax bracket. If you take the distribution before the age of 59½, you may also incur a 10% early withdrawal tax penalty.
The lump sum offer you receive is not only based on your earnings history and years of service but also current interest rates. Because the offer amount is calculated by discounting expected future payments based on their current present value, the amount of your lump sum payment will decline as interest rates go up.
In sum: choosing between a monthly benefit and lump sum pension offer
As you can see, deciding whether to take a lump sum pension offer versus a monthly payment is highly individualized—and not always so clear-cut. Whichever decision you make, know it will likely have a significant impact on your retirement. That’s why these decisions are best addressed by working with a CFP® professional, who can help guide you based on your own unique situation.
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.
Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
