When You Should Take the Lump Sum Over the Pension

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When You Should Take the Lump Sum Over the Pension
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If you have worked at a company for 10 years or more, one day you may very well be faced with the following situation:  Your company is offering you a chunk of money or a perpetual monthly amount of income to either retire today or to help you “retire early.”

So, should you take a monthly pension, or a large one-time lump sum (typically rolled over into your IRA)?  Which one is better for you in the long run?

When a lump sum makes more sense than a pension

Clark recently posted his thoughts about the topic.  He believes that you are nearly always better off taking the monthly amount – and not a lump sum.   Part of his reasoning is that most companies don’t want to be on the hook for a monthly amount if god-forbid you live until age 100. Companies would rather you take the lump sum, and never be on the hook to pay you ever again.  To Clark’s point, this is often precisely why you shouldn’t take the bait.

However, this is really not the kind of decision that can be an always or never answer.  Instead, I think that this is really a forever circular debate.

Think of it in terms of the 6% rule, or “does your pension pass the 6% test?”

If your monthly pension offer is 6% or more of the lump sum then it may be worth considering.  If it’s below 6%, then you can likely do just 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 case, 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 forever is a tall task, so taking the monthly amount here (7.5% is greater than 6%), tells me that the monthly amount may be a better deal long term.

Keep in mind, part of what a pension is doing is technically just paying 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 the money should last for 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. Twenty years will get you to age 85 using 5% each year in an environment where you make a zero percent return.  My point in bringing up this math is that any monthly pension you elect to take over a lump sum amount should be well north of a 5% annual return/payment (that’s why I set my rule of thumb at 6%).

At least for the first 20 years, a 5% withdraw rate will give you an “income” by simply paying yourself with 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 a 5% payout.  In this case, the monthly pension amount is offering you a return (for life) of about 5%.  Remember, for the first 20 years earning zero, you could do the same before you run out.  All you have to do is make a very modest return (call it 2% per year), and you would be forever ahead of what the company’s monthly pension would do for you.  In this case 5% is less than my bare minimum benchmark of 6%, so you would likely be better off taking the lump sum of $170,000.

Other factors to consider:

  1. Your age to begin a monthly pension vs. the lump sum.
  2. Your projected longevity. The longer you live the more valuable the monthly pension amount will likely be worth to you.
  3. The type of pension payout you elect.  Is it based just on your life and then stops after you die, or does it continue for your spouse’s life as well? Is there a “period certain” option that would be paid to your beneficiaries for a set number of years even if you pass away soon after taking the monthly pension? 
  4. The solvency of the company “promising you the pension” for 20 plus years, and does the Pension Benefit Guaranty Corporation (PBGC) back up your payments if your former company paying the pension goes out of business? 
  5. Will you at some point need a “lump sum” amount of money for an emergency?  Maybe you already have that covered with other accounts or resources, so think of the lump sum offer in the context of other assets on hand.

Bottom line:  There’s a lot to consider when it comes to the lump sum vs. pension question.  The first step is to do the math, and see if the monthly pension amount at least passes the “6% test.”  Then beyond the 6% test consider how the other variables (above) tip the scales towards a monthly amount or a lump sum.


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Wes Moss About the author: Wes Moss
Wes Moss is the host of Money Matters – the country’s longest running live call-in, investment and personal finance radio show – on WSB radio. He is the Chief Investment Strategist at Capital Investment Advisors (CIA), and a partner at Wela, a digital financial advisory service. In 2014 and 2015, Barron’s ...Read more
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