Should I Take The Lump Sum From My Pension?
Are you about to receive a pension?
Great, you’re among the fortunate few!
Now, you are probably wondering: Should I take the lump sum from my pension or take income for life?
Deciding how to take your payout can be one of the most powerful retirement decisions you make because it can impact your entire retirement income plan for the rest of your life.
Generally speaking, you have two broad options:
Lump-sum (which you could rollover into an IRA)
Lifetime income payments (which translate to monthly payments)
Each comes with pros and cons and several considerations dependent entirely on your unique financial and personal circumstances.
Here’s how to tell if you should take the lump sum or lifetime income payments from your pension.
Pension Plan Basics
A pension is a type of retirement plan offered through an employer as a benefit, much like the far more common 401k plan. Although both types of plans are meant to provide you with a source of income in retirement, the way they do it is vastly different.
Understanding Defined Contribution Plans
A 401k is a defined contribution plan, meaning you save money by placing a specified amount of your paycheck into the plan each pay period.
So, the total amount of money you have in retirement is primarily determined by how much you contribute and your contributions’ rate of return. In this case, the contribution is known or “defined,” but the benefit is not.
Why A Pension Plan Is Different
A pension is a defined benefit plan and functions oppositely. Typically, employees do not contribute to the pension but instead accrue a retirement benefit that their employer will pay them once they retire.
With a defined benefit pension plan, the employer is on the hook for ensuring there is enough money in the plan to fund the promised benefit. However, companies don’t simply make an educated guess on that number.
Qualified pension plans are required to have trained professionals, enrolled actuaries, determine that companies adequately fund the plan every year. In addition to the stringent accounting requirements, pensions are also covered by the Pension Benefit Guaranty Corporation, or PBGC, which protects retirees in case a plan is unable to pay earned benefits.
How Pension Plans Determine Retirement Benefits
So how does the employer define the benefit that employees receive?
Each plan has a specific benefit formula. The most common type of formula bases the benefit calculation on two factors:
How much the employee earned, and
The number of years they were employed with the company.
Often, the higher the employee's income and the longer they were employed, the more significant the benefit.
Retirees usually have several options for how they wish to receive their benefit as well. The most basic decision you will have to make is whether to receive your benefit as a single lump sum or as a stream of regular payments—often for life.
In some circumstances, companies offer employees a buyout, where the company agrees to pay you a certain amount of money and in exchange, releases itself from future payment obligations. In the case of a lump-sum offer, you may need to think about these issues earlier than initially planned, especially if the company is terminating the pension plan.
Evaluating Lump-Sum vs. Lifetime Income For Pension Payouts
If you have the option between taking your benefit as a lump sum or lifetime income payments, then you’ll want to do a little analysis. Below are a few factors that can help bring context to your decision.
Start by looking at the raw numbers, and consider how the lump-sum distribution would compare to the recurring payments for different lengths of time.
For example, if you collect payments for 10 years, how does that stack up to the lump sum payment? Could you have invested the lump sum (in an IRA, the stock market, etc.) and reasonably expected to withdraw more than the payments provided you over that time?