Lump Sum or Monthly Pension: Which Is Right for You?


Believe it or not, there are still a few people out there who are lucky enough to have pensions through their employer. Over the years, defined benefit plans like pensions have, for the most part, been replaced with defined contribution plans such as 401(k)s. For those who do have pensions, employers are increasingly offering the choice of taking a lump sum or monthly pension payments; most companies have zero desire to be pension fund managers.

Here are considerations for each option that can help you decide which is right for you.

How Is Your Lump Sum Calculated?

If you’re offered a lump sum, you may wonder how your employer arrived at the specific number of your payout. A pension is essentially a fixed annuity – something that insurance companies are very good at calculating. They take your monthly payment, assume a rate of return on their investments and estimate your life expectancy from actuarial tables. From there, the lump sum is a simple present-value calculation.

When you’re deciding between a lump sum or monthly pension payments, it’s a good idea to double-check their math to ensure that the lump sum figure is reasonable. Several online calculators exist that can help you with a reasonableness check.

While you may want to adjust the life expectancy based upon your family history, you’ll most likely find that there is no significant monetary benefit for one option over the other. Unfortunately, while the math may be straightforward, making the decision may not be so simple.

When Taking a Lump Sum Makes Sense

There are pros and cons to both choices. Generally, choosing the lump sum option will give you more flexibility on how you can invest and access your savings. Often in retirement, big expenses pop up from time to time. You may occasionally need to buy a new car, replace the roof, or downsize to a smaller home.

The lump-sum option also allows you to better control the timing of taxes on your distributions, to an extent. Where pension payments are taxable as you receive them, taking the lump sum allows your funds to grow if you don’t need them immediately. This can allow you to create a tax-efficient withdrawal strategy before you turn 72 and your required minimum distributions (RMDs) begin. Having a few retirement years in a lower tax bracket can allow for tactical opportunities such as partial Roth IRA conversions or 0% capital gains taxes on appreciated stock.

Another consideration that may make the lump sum option more favorable is the current interest rate environment. Due to low rates, your pension plan may be forced to use lower returns in their lump sum calculations. Of course, this all depends upon how your pension funds are invested.

Finally, it’s important to consider the financial strength (or weakness) of your employer. As the plan sponsor, they are ultimately responsible for funding it. Of course, they’ll almost always hire a plan administrator and institutional investors to manage the assets. However, your pension payments are still tied to the fate of your company. Should your employer run into financial issues or go bankrupt, your pension may hang in the balance.

If the unthinkable happens and your company does go out of business, the Pension Benefit Guarantee Corporation (PBGC) would step in to take over the management of your company’s pension plan. The PBGC is a federal agency created to protect the pension plans of private sector companies.

Unfortunately, the PBGC has a maximum monthly pension amount that it will cover. If you have a large pension, you may see your monthly benefit reduced during a company bankruptcy. Sadly, this occurred often during the Great Financial Crisis.

When Taking Monthly Pension Payments Makes Sense

While there are plenty of benefits for taking the lump sum, don’t rule out the monthly pension payment option quite yet. If your employer is financially stable, there are still situations where you would want to consider this option.

Managing your own investments isn’t right for everyone. In fact, according to a MetLife study, approximately one out of every five people who choose the lump sum option will spend it all during the first six years of retirement! If you are concerned about making sure you have a guaranteed retirement paycheck, then the monthly pension payment option might be the right choice. Taking the lump sum will require careful investment management over the years to ensure that it provides you with a monthly retirement paycheck.

Additionally, your pension may have certain features that make it more attractive than simply taking a lump sum. A cost-of-living adjustment (COLA) feature increases your pension payments over the years to ensure your income keeps pace with rising costs. This would reduce the need to take a lump sum and invest it more aggressively for this very same reason.

Finally, your pension may offer spousal and beneficiary benefits worth considering. Most common would be a “joint and survivor” option that continued payments to your spouse should you pass away. This is one way to ensure guaranteed income to your spouse should something unfortunate happen.

Lump-Sum or Monthly Pension Payments?

In my experience over the years, the lump sum option has been the right fit for most retirees, however, it’s not a slam-dunk. If you have other retirement savings, taking the lump sum and including it into your retirement portfolio may allow you to generate higher income over your retirement than you would otherwise have with the pension payments. Of course, past performance is no guarantee of future results. Risk and return are always related.

However, if you feel like you might be the one person in five who spends it all in the first six years, then the monthly pension payment option might be the best choice for you, especially if your pension has a cost-of-living adjustment feature. Dealing with the ups and downs of the stock market with your retirement savings isn’t for everyone.

Choosing between a lump sum or monthly pension payments isn’t an easy decision with clear-cut answers. We can only do our best to make a good decision based upon all the information we have today and move on. We’ll only know what was best in hindsight.

If you’d like help deciding between a lump sum or monthly pension payments, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.

As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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