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?
What about 15 years? 30 years? The longer you draw out the timeframe, the more likely it is that taking the payment stream is the more lucrative option.
So what do you do with that information?
First, think about how long you might expect to live and ask yourself which option will most likely provide you with the most benefits.
Does your family have a history of living well into their 90’s or do they have normal or shorter lifespans on average?
What about your own physical well-being? Are you in good shape with no medical complications, or do you have health concerns that suggest you may not live another 30 years?
Personal Comfort Level
This decision is not a simple math problem. Sure, you need to consider the raw numbers (total benefit, interest rates, etc.), the length of time you plan to collect benefits, life expectancy, health, dependents, beneficiaries, and more, but those elements aren’t the end-all-be-all. Your personal preferences matter, too.
Does the thought of having a steady and guaranteed income put you at ease? Peace of mind absolutely deserves a place in your decision. After all, you should enjoy your retirement and not stress about money all the time.
Or, does the idea of a lump that you could access if you needed to sound better? Maybe you’re excited about the possibility of reinvesting those funds in other areas of your life. Or perhaps quicker access to the money could help you achieve one of your significant financial goals.
Keep in mind that the lump-sum option will come with more sophisticated investment decisions. You’ll have to build a proactive investment plan and withdrawal strategy to make the most of the opportunity. Selecting the regular payment stream doesn’t have this added layer.
It's also critical to evaluate the tax implications of each choice. By taking a lump sum and investing, you may not have a clear idea of your future tax responsibilities as it depends on where you invest, investment returns, and when you withdraw it. Remember, you will need to take required minimum distributions (RMDs) if you invest in a traditional IRA, which could increase your income tax liability for the year.
If you choose the monthly payments, you'll likely have to pay income tax on the distributions. Since it's a set number each month, you'll have more consistency in your annual tax planning.
No matter your choice, we’ll help you look at the implications for your entire financial picture: income goals, cash flow, tax projections, and more.
Don’t lose sight of the fact that the whole point of a pension is to provide for you in retirement.
Consider how your other sources of monthly income come into play. Do you have other steady sources of income from Social Security or annuities?
Then, you may not need to take lifetime payments from your pension. If your other sources of income are less steady, your pension payments may be able to provide you with some stability.
How To Choose What’s Right for You
Various factors are at play when deciding between a lump sum or lifetime income, but ultimately, it's up to you to choose what's best for your money and life. It's so beneficial to have a trusted financial advisor in your corner to help you understand your options and make the best choice for your situation.
If you're nearing retirement and need help figuring out the best choice for you, talk to us at Covenant Wealth Advisors. We can walk you through critical retirement income decisions and set you up for ultimate success in your retirement years.
Broderick is a personal financial advisor and fee-only financial planner with Covenant Wealth Advisors. He manages investment portfolios for individuals age 50 plus with over $1 million in investments.
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