Several years ago, my previous employer offered former staff members a lump-sum pension buyout. We were given the option of receiving a steady monthly amount over the course of retirement or a one-time cash payment (ideally put directly into an individual retirement account (IRA) to avoid taxes and penalties and to allow the assets potential for future growth). In addition to making this decision for myself, because I was a financial adviser, I was able to help several former co-workers evaluate their options.
This difficult decision came to mind again recently when General Electric offered a lump-sum payment option for roughly 100,000 eligible former employees who had not started taking their monthly pension plan payments.
If you find yourself having to choose between a lump sum or an ongoing monthly payout (annuity), there are many factors to consider. I believe it’s most helpful to focus on the following three fundamentals:
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- Your goals
- Your risk tolerance
- Your other financial resources
Goals
While evaluating the pros and cons of a lump-sum offer may be challenging, think of it as an opportunity to re-evaluate your goals. If your primary concern is that you may run out of money in retirement, sticking with the pension annuity may make sense for you. Pensions generally offer survivor benefit options as well, which can provide income to you and, in the event of your death, to your spouse. However, if leaving assets to the next generation is more important to you, then the lump sum, if reinvested, could be a better choice.
While a steady lifetime income stream and leaving an estate are significant goals to weigh, there may be others to consider. Taking the lump sum offers more flexibility to spend the money when you want. That’s probably a good thing, but it could be a problem if you’re not disciplined. And be careful not to overestimate that flexibility — if you transfer the funds into an IRA you will have required minimum distributions (RMDs), and the tax bills associated with them, starting at age 70½.
Another goal, especially for some of my younger ex-colleagues, was to consolidate their assets in one IRA. For them, it wasn’t worth the hassle of staying connected with the company just to collect a tiny monthly pension check years later.
Risks
Taking the lump-sum payment requires you to manage your investments. So it’s important to weigh the classic trade-off between investment risk and return. To help evaluate whether the annuity or the lump sum may be your better choice, you can figure out what kind of a return you’d need to earn on a lump sum to equal or surpass the guaranteed payments you’d receive from the annuity.
Employers generally determine the lump-sum amount equivalent to an annuity stream based on two key assumptions: your life expectancy and a rate of return (also called a discount rate). You can estimate that rate of return with the help of your investment provider, financial planner, or even a spreadsheet. If you’re eligible to start annuity payments right away, the Microsoft® Excel® “Rate” function calculates the approximate return using three inputs: 1
- number of years of expected annuity payments, based on your life expectancy,
- annual annuity payment amount, and
- lump sum offered.
For example, suppose you’re a 64-year-old woman and have the choice between $28,000 per year for life (starting this year) and a $375,000 lump sum. Your remaining life expectancy (using a Social Security table) is around 21 years. The spreadsheet formula to calculate the implied rate of return is:
- =RATE(21,28000,-375000)
In this case, the annuity would have an implied 4.5% annual rate of return. Longer time periods of receiving payments would result in a higher return rate. For example, a 30-year period results in a 6.3% estimated return, while a 15-year period implies a 1.5% return. As you’d expect, the longer one’s lifespan, the higher the estimated return for the annuity and the more inclined you should be to stick with it.
Is a 4.5% return good or bad? Compared with a low-risk investment like a 10-year Treasury note (currently yielding around 2%), an annual return of 4.5% seems like an excellent rate in today’s environment. On the other hand, the historical annualized return of a diversified portfolio over the 15 years ended Aug, 31, 2019 is 7.18%. 2
There’s no “right” answer — and again, it depends on your goals and risk tolerance.
If age restrictions require you to wait to collect your annuity payments later, the calculation is slightly more complicated. 3 Either way, the higher the implied rate of return, the more risk you’d need to take with your invested lump sum to outperform the annuity.
Regarding the recent GE offer noted above, information I’ve received indicates the annuity’s implied rate of return is over 6%, based on average life expectancy and starting payments at age 60. For many people, especially those who expect to live longer, that would make the annuity attractive.
Keep in mind, though, that there are some risks with the pension option. If the pension plan is terminated due to the company’s bankruptcy, the plan would be taken over by the Pension Benefit Guaranty Corporation (PBGC). If this were to happen, large monthly pension benefits could be reduced. If you’re truly concerned about the prospects of your former employer, you may lean toward taking the lump-sum payment.
Also remember that most pension amounts are fixed—they do not increase with inflation. And at a 3% rate of annual inflation, your purchasing power could be cut in half after 24 years.
Additional Financial Resources
Your pension is likely just one part of your retirement income plan. If you expect your Social Security benefits to cover a large portion of your expenses in retirement, supplementing that income with additional steady income may not be your top priority. In this case, investment returns of a balanced portfolio on the lump sum could be meaningful for you or your family. The lump sum could also offer the flexibility to delay claiming Social Security, which would increase your monthly benefits.
On the other hand, if you do not think your Social Security benefits will meet a large portion of your regular expenses, a guaranteed monthly pension payment may be more desirable. In addition, having consistent income may help you feel more comfortable with risk in the rest of your portfolio.
Pension or Lump Sum: What Decision Did I Make?
You may be wondering what decision I made about the lump-sum offer from my former employer. At that point in my 40s, I was more concerned about supporting my family in the event of my death than I was about outliving my assets. I was also comfortable taking some risk with my portfolio. So, I took the lump sum, putting it directly into an IRA. Some of my coworkers made the opposite decision to keep the annuity, with perfectly legitimate reasons.
If you’re faced with this decision, you can seek assistance from your investment provider or a trusted adviser. If you don’t have a trusted adviser, consider seeking advice from a planner with a fiduciary responsibility to you.
1 -The trademark displayed is the property of its respective owner. Use does not imply endorsement, sponsorship, or affiliation of T. Rowe Price with the trademark owner.
2 - Past performance cannot guarantee future results. The diversified portfolio assumes the following weights: 36% Russell 1000 Index, 6% Russell 2000 Index, 15% MSCI EAFE Index, 3% MSCI EM Index, 28% Bloomberg Barclays U.S. Aggregate Bond Index, 4% JPM Global High Yield Index, 4% Bloomberg Barclays Global Aggregate Ex-USD Bond Index, and 4% JPM Emerging Bond Global Diversified Index, and assumes monthly rebalancing. Data as of 31 August 2019. Information is shown for illustrative purposes only and does not represent the performance of any specific security or T. Rowe Price product.
3- For example, suppose you’re 54, expect to live to 80, and have the choice between a $75,000 lump sum today or $8,900 per year starting at age 60. In this case you would use the IRR function in Microsoft Excel, which would indicate that the annuity has an approximately 6.3% return for that longevity assumption.
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