How To Decide If You Should Take The Lump Sum Versus Monthly Pension Payments

Imagine this: you’re plugging away at work at the job you’ve held for years, and all of a sudden someone from the company approaches you with an offer. What’s on the table? Your retirement. The offer? A one-time payout of money or an ongoing monthly stream of income.

Increasingly, companies are offering this type of buyout as a way to reduce their future pension obligations. For employers, the long view is that the impact of pension plans on the company’s financials will be reduced. For employees, this business strategy translates into a trade-off: lots of money today or a more modest amount over time.

How you answer this either/or question will make an indelible mark on your overall retirement picture. So, how do you decide between taking the large lump sum (typically rolled over into your IRA) or monthly pension? The answer, as always, depends on your unique circumstances.

If you expect to be retired a very long time the monthly payments for life might be your best option, Should you live to be 100, your former employer could be financing your centenarian birthday party. This is exactly why companies want you to take the lump sum. It’s a payoff, plain and simple.  Take it today and they’ll never have to pay you another cent.

But because everyone’s retirement situation is so different, the answer to this question can’t be framed in “always” and “never.” Instead, the best answer for you is one based on your individual retirement landscape.

Think of it in terms of the 6% Rule. It’s really simple. If your monthly pension offer is 6% or more of the lump sum offer, then you may want to go for the perpetual monthly payment. If the number is below 6%, then you likely can do as well (or better) by taking the lump sum and investing it, and then paying yourself each year (a form of your own personal pension that you control).

Here’s how the math works: take your monthly pension offer and multiply if by 12, then divide by the lump sum offer.

Example 1: $1,000 a month for life beginning at age 65 or $160,000 lump sum today?

$1,000 x 12 = $12,000 divided by $160,000 equals 7.5%.

In this scenario, you would have to make approximately 7.5% per year on the $160,000 to earn a steady $12,000 a year. Earning 7.5% a year consistently and in perpetuity is a tall order. Taking the monthly amount in this case (7.5% is greater than 6%), may likely be a better deal over the long term.

Bear in mind that a pension theoretically pays you back your own money. On your own, you can withdraw 5% per year from any lump sum (even if the funds are earning 0%). And, speaking conservatively, the money should last you 20 years (5% x 20 years = 100% withdraw). Twenty years is a long time, especially when you may not begin a pension until age 65. Over those twenty years, you’ll get to age 85 using 5% each year in an environment where you make a zero percent return.

The point of using math as an illustration is to show that any monthly pension you elect to take over a lump sum should be well north of a 5% annual return/payment, hence the 6% Rule. At least for the first 20 years, a 5% withdraw rate will give you “income” by way of paying yourself your own money.

Example 2: $708 a month for life or a $170,000 lump sum today?

$708 x 12 = $8,496 divided by $170,000 equals 5%.

Here, the monthly pension amount is offering you a return for life of about 5%. Remember, for the first 20 years earning zero percent, you could do the same before you run out of money. If you made even a modest return (say, 2% per year), you would be far ahead of what the monthly pension would pay you. In this case, 5% is less than my bare bones benchmark of 6%, so you would probably be better off taking the lump sum of $170,000.

Some other factors worth considering if you’re faced with a lump sum/monthly pension option:

1. Your age to begin a monthly pension vs. the lump sum.

2. Your projected longevity. Of course, the longer you live, the more valuable the monthly pension amount is worth.

3. The type of pension payout you elect. Is it based on your life only or are there provisions for a surviving spouse? Is there a “period certain” option that pays plan beneficiaries for a time even if you pass away soon after taking the monthly pension?

4. The solvency of the company paying the pension for 20 plus years. Does the Pension Benefit Guaranty Corporation (PBGC) back up your payments if your former employer goes out of business?

5. The likelihood that you’ll need a “lump sum” for a future emergency. Got that covered with other accounts or resources? Consider the lump sum offer in the context of your other assets.

As you see, there’s a lot to consider when it comes to lump sums versus monthly pensions. And the answer to your question is highly individual. Take the first step and do the math to see how your offer fares under the 6% Rule. Beyond that, weigh the variables above to see which way the scale tips for you.

Use our Retirement Calculator to learn more about your retirement options.

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