Should you take your pension in a lump sum or monthly payments?

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Pension statement
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Pensions are increasingly rare these days. The reason is simple: Offering pensions requires companies to make an expensive, long-term commitment to its retirees.

So it’s understandable that even companies that still provide a pension benefit are looking to reduce their costs and risks. One strategy for achieving that goal is to offer pensioners a one-time lump payment instead of a lifetime of monthly checks.

What should you do if you are offered a one-time cash payout of your pension instead of the regular set-up of monthly payments?

The answer is: It depends.

I get this question a lot. Here in Atlanta, many big companies — employers like Coca-Cola and AT&T — are offering employees lump-sum pension buyouts. It’s becoming more and more common for those lucky folks who still have pensions to get a similar offer and it can come whether you’re still on the job or already retired.

In my book, You Can Retire Sooner Than You Think, I discuss the ins and outs of pensions. I even have a section on page 84 devoted to exploring how to make the right choice when it comes to taking the (often hefty) lump sum versus keeping the steady, modest monthly income stream.

How you choose to answer this question can have a long-term impact on your retirement. I know it’s hard to think rationally when you have cold hard cash dangled in front of your face, but be sure to research to determine what’s best for your overall financial well-being.

Of course, everyone’s financial landscape and retirement horizon are different. But I do have a general rule of thumb to follow when considering the one-time pension payment (assuming you rolled the funds over into your IRA) or the monthly check. It’s called the 6% Rule.

Here’s what the 6% Rule says

If your monthly pension offer is 6% or more of the lump sum offer, then you may want to go for the ongoing monthly payment. If the number is below 6%, then you likely could do as well (or better) by taking the lump sum and investing it into an IRA and then paying yourself each year (a form of your own personal pension that you control).

The math behind the rule is straightforward: Take the monthly pension amount and multiply it by 12, then divide this number by the lump sum offer.

Bear in mind that a pension, in theory, is paying you back your own money. And on your own, you can withdraw 5% per year from any lump sum offer you take (even if the funds are earning 0%). Speaking conservatively, the money should last you 20 years (5% x 20 years = 100% withdrawal). 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.

Let’s walk through a couple of examples:

Say your pension is for $1,200 a month for life beginning at age 65. You’ve been offered a $180,000 lump sum today.

$1,200 x 12 = $14,400 divided by $180,000 equals 8%.

In this scenario, you would have to make approximately 8% per year on the $180,000 in order to earn a steady $14,400 a year.

Earning 8% a year consistently and in perpetuity is a tall order. Taking the monthly amount in this case (8% is greater than 6%) may be a better deal over the long haul.

What if you are scheduled to get $700 per month or are offered that same $180,000 buyout? Now what would you do?

$700 x 12 = $8,400 divided by $180,000 equals 4.7%.

Here, your monthly pension amount is offering you a return of just shy of 5%.

In this example, because 4.7% is less than 6%, you may be better off taking the lump sum option. 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, 4.7% is less than my bare bones benchmark of 6%, so you would probably be better off taking the lump sum of $180,000.

Take a look at these other factors worth considering if you ever face a lump sum/monthly pension option:

  • Your age to begin a monthly pension vs. the lump sum.
  • Your projected longevity. The longer you live, the more valuable the monthly pension amount is worth.
  • 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
  • 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?
  • The likelihood that you’ll need a “lump sum” for a future emergency. Consider the lump sum offer in the context of your other assets.

As you can see, there are a lot of factors to consider in the lump-sum vs. monthly pension decision process. And the answer to your question is highly unique.

Take the first step and do the math to see how your offer fares under the 6% Rule; it’s where I start when helping families make this difficult choice. From there, consider the variables above to see which way the scale may tip for your individual situation.

Disclosure: This information is provided to you as a resource for informational purposes only and should not be viewed as investment advice or recommendations.  Investing involves risk, including the possible loss of principal. There is no guarantee offered that investment return, yield, or performance will be achieved. There will be periods of performance fluctuations, including periods of negative returns.  Past performance is not indicative of future results when considering any investment vehicle. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.

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Wes Moss About the author:
Wes Moss is the host of Money Matters ' one of 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 2017, Barron's named Wes ...Read more
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