Workers with defined benefit pensions may be offered the chance to collect a one-time, lump sum payment instead of monthly pension benefits for life.
Making this decision involves evaluating a number of factors, including the lump sum amount, the amount of the monthly payments and the age of the recipient when the offer is made. Other factors to consider include the recipient’s health, whether the pension will pay benefits to a surviving spouse, as well as the recipient’s level of financial literacy, self-discipline and need for financial flexibility. When faced with a choice like this, a financial advisor can help you evaluate your options and make an informed decision.
Lump Sum vs. Monthly Payments
A pension beneficiary who is offered $250,000 in a single payment in lieu of $2,750 monthly payments for life can start by calculating the potential cumulative value of the monthly payments. To do this, they need to estimate how long they will likely live.
According to Social Security’s life tables, a 60-year-old male has an average life expectancy of about 20 years. If the pension will begin making payments at age 65 and continue making them until the beneficiary dies in 15 years at age 80, he’ll collect approximately 180 monthly payments for a total of $495,000.
If the beneficiary instead opts for the lump sum, he can immediately begin investing it at age 60, When he retires five years later, he can start taking $2,750 monthly withdrawals. In order for the $250,000 to last until he reaches 80, his investments would have to generate an average annual return of at least 5.9%.
Now assume the pension beneficiary is a 55-year-old woman and that her monthly payments will begin at age 65. According to the Social Security Administration, she can expect to live to age 83. In this case, the monthly payments have a somewhat higher value, adding up to $594,000. However, because the lump sum would be invested for a longer period before she starts her withdrawals, her investments only need to grow at an average rate of 4.84% per year for the money to last until age 83.
In both these scenarios, the required return for the lump sum payment to at least match the value of the monthly payments is not unreasonable. It’s possible that a well-managed portfolio could exceed these average returns, making the value of the lump sum option greater than the monthly payments.
As you can see, decisions like this one often require some calculations and assumptions. A financial advisor can help you run the numbers and weigh your options.
Other Considerations
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In reality, deciding between a lump sum or monthly benefit is likely to be somewhat more complicated than these simplified scenarios. For instance, many pensions have a survivor benefit that will pay all or a portion of the retiree’s benefits to a surviving spouse after the retiree’s death. If a spouse survives the original pension recipient, this can add significantly to the value of the monthly benefit option.
Ultimately, of course, longevity is not assured. If a monthly benefit recipient dies earlier than expected, it reduces the value of the monthly benefits. If they live longer than expected, it increases the value. For this reason, details about the recipient’s health can be important considerations. Someone in good health with a family history of living to an older-than-average age might assign a greater value to the monthly payments.
Inflation and investment returns are two other unpredictable factors. While 7% can be seen as a reasonable expectation for average annual return based on historical investment records, there’s no guarantee that future performance will match that. Similarly, if inflation increases, this will reduce the purchasing power of a monthly benefit unless the pension has a cost of living adjustment. Investing a lump sum provides the opportunity for returns that might help overcome the purchasing power erosion of a spell of rapid inflation.
Safety is a key concern when it comes to paying for retirement. Pensions are guaranteed, but investment returns are not. A recipient who lacks the financial literacy to invest a lump sum wisely may be better off with a monthly benefit. Similarly, it’s possible for someone who comes into a large sum of money to spend it frivolously rather than investing it wisely to pay for living expenses in retirement.
While a taking lump sum may be inherently riskier, it also provides flexibility that may be an advantage in some situations. For example, if someone has significant debt, it may make more sense to take the lump sum and pay off what’s owed rather than continue servicing the debt while receiving monthly benefits.
If you’re facing a similar decision or scenario, consider talking it over with a financial advisor first.
Bottom Line
When faced with a choice between taking a lump sum or receiving monthly pension payments, key factors to consider include the age of the pension beneficiary when the offer is made, the beneficiary’s life expectancy and the size of the lump sum and the amount of the monthly payment. Other factors to consider include details about the pension, including whether it offers spousal benefits or inflation adjustments.
Retirement Planning Tips
A financial advisor can bring objectivity, experience and insight to the task of evaluating a choice between monthly pension benefits and a lump sum. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
SmartAsset’s Investment Return and Growth Calculator offers a quick, simple and free way to see how much your portfolio could be worth in the future. This can come in handy if you take a lump sum pension payout and want to reinvest it in the stock market for a number of years.
Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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