Should I Take the Lump Sum on My Pension?

Q: I’m 53, and many years ago I worked for a company that is scheduled to start paying me a pension when I’m 65. This company just now contacted me and offered to give me a lump sum today, or to start receiving a smaller monthly pension (than I’d get if I waited 12 years) this October. The specifics of the three options are as follows: I can wait 12 years and receive $446 per month, I can start receiving $267 per month this October, or they will give me a lump sum of $47,243 today. Which option do you think I should take?

A: We’ve seen a great number of companies seeking to buy out their pension obligations the past few years. These buyouts are being extended to current retirees, as well as to people like you with deferred vested pensions. (In addition, many companies offer a lump sum pension option at the time of retirement, where an employee can opt to receive a single chunk of cash in lieu of a monthly payment.)

There are a number of factors that need to be considered when evaluating which option is best. First, you need to calculate the expected rate of return you could earn from the money should you decide to take the lump sum now. Simply, if you take the money today, how and where could you invest it so that you could earn at least $267 per month for the rest of your life? The lower the rate of return required to reach that magic $267 number, the more favorable the lump sum. (By contrast, the higher the required rate of return, the less desirable the lump sum.)

One way to run the numbers and calculate the best course of action is to simply figure out how much you would need to (or could) earn while maintaining your principal (not spending any of the lump sum amount). At $267 per month, you would need to earn about 6.8% per year to maintain the principal of the lump sum ($47,243).

But a more accurate way to calculate the efficacy of the lump sum is to figure the required return based upon your life expectancy. After all, the monthly pension payments will cease upon your death and will not pay into perpetuity. You’re 53, and, according to a life-expectancy table provided by the IRS, you can reasonably expect to live 31 more years. Based upon receiving $267 per month for 31 years (and not forever), this brings the required return needed down to 5.6%.

The question you should ask yourself is whether or not you could earn 5.6% on your money. If there’s a high probability that you can, then take the lump sum. But if you don’t think you can earn that high of return, then the next step is to ask yourself a few more questions:

Are you married? If you would accept a reduced monthly pension in order to have a survivor’s benefit, then you should run the numbers, not with the $267 single life annuity you are being offered by your former employer, but with a lower joint and survivor annuity. If your employer’s plan is like so many others that I’ve seen, you’ll be forced to take a 10% reduction in benefits in order to protect your spouse. This would drop your required rate of return from 5.6% down to roughly 4.7%.

Some other things to consider: If you don’t believe you’ll live to a normal life expectancy, due to an existing health issue or family history, this would certainly tip the scales in favor of you taking the lump sum. Conversely, if you think there’s a possibility that you’ll live well beyond the norm, the monthly pension (at age 65) becomes more attractive.

Another key questions is, what would you do with the lump sum? If your idea is to have the money placed directly into an IRA rollover account and let it grow until you’re 65, then that’s fantastic! But if you plan on having the lump sum paid out directly to you and, say, you place the money in a savings account, you’ll not only incur a large tax bill today, you’ll be setting yourself back by ensuring a lower retirement income in the future.

Bottom line is this: If you have a good track record for either managing your own money or relying upon an adviser to do it for you, you should consider taking the lump sum, rolling it into an IRA and letting it grow until at least age 65. On the other hand, if your health is good, but your investment performance has been subpar, opting for the monthly pension at age 65 may be your best bet.

All things considered, the one thing I would strongly recommend against is taking the monthly pension this October. You’ll enjoy 12 years of retirement income from now until age 65, but at precisely the time you’re most likely to need it, you’ll wind up with less income during your golden years.

Scott Hanson, CFP, answers your questions on a variety of topics and also co-hosts a weekly call-in radio program. Visit MoneyMatters.com to ask a question or to hear his show. Follow him on Twitter at @scotthansoncfp.