If you are approaching retirement and you are receiving a pension,you may wonder if you should you accept the traditional, lifetime monthly payments or take a lump-sum distribution.
You might be tempted to go with the lump sum for the large single disbursem*nt of money. However, before you make a decision about your financial future, learn how they compare. Each payment strategy has difference financial consequences. Let's look at the pros and cons of taking a lump sum versus a regular pension payment.
Key Takeaways
- Pension payments are made for the rest of your life, no matter how long you live.
- Lump-sum payments allow you to immediately spend or invest your pension as you like.
- Studies show that retirees with monthly pension income are more likely to maintain their spending levels than those who take lump-sum distributions.
- People who take a lump sum may outlive the payment, while traditional pension payments continue until death.
- If a pension administrator goes bankrupt, pension payments could stop, though PBGC insurance covers most people.
Lump-Sum Payments
A lump-sum distribution of a pension is a one-time payment from your pension administrator. By taking a lump sum payment, you gain access to a large sum of money, which you can spend or invest as you see fit.
"One thing I emphasize with clients is the flexibility that comes with a lump sum payment," says Dan Danford, CFP, Family Investment Center of Saint Joseph, Missouri. A pension payment annuity "is fixed (occasionally COLA-indexed), so there is little flexibility in the payment scheme. But a 30-year retirement probably faces some surprise expenses, possibly large. The lump sum, invested properly, offers flexibility to meet those needs and can be invested to provide regular income, too."
They type of your pension payment may affect your children, as well. Consider whether you want to leave something to your loved ones after your death. Once you and your spouse die, the pension payments might stop. On the other hand, with a lump-sum distribution, you could name a beneficiary to receive any money that is left after you and your spouse are gone.
Rolling over a lump sum
Income from pensions is taxable. However, if you roll over that lump sum into your IRA, you will have much more control over it when you remove the funds and pay the income tax on them.Of course, you will eventually have to take the required minimum distributions (RMDs) from your IRA, but that won’t happen until age 73.
"Rolling your pension into an IRA will give you more options," says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, MA. "It will give you more flexibility of investments that you can invest in. It will allow you to take distributions according to your required minimum distribution (RMD), which in many cases, would be lower than your planned pension payments."
Rolling a lump sum pension payment into an IRA will allow you to plan when you take your distributions. Thus you can plan when and how much you want to pay in taxes.
Regular Pension Payments
A regular pension payment is a set monthly payment payable to a retiree for life and, in some cases, for the life of a surviving spouse. Some pensions include cost-of-living adjustments (COLA), meaning payments go up over time, usually indexed to inflation.
Some argue that the main feature people like about lump-sum payments—flexibility—is a reason to avoid them because it can encourage overspending. With a regular pension checks, you don't immediately have access to a large sum of money.
A 2020 report by the Consumer Financial Protection Bureau found that retirees with pension income were more likely to remain financially stable than those who had cashed out the lump sum. Of those with regular payments, 73% could maintain the same spending levels after five years, compared to only 56% of those who had chosen the lump sum.
A lump sum also requires careful asset management. If you put the money into conservative investments so you don't lose money, the growth may not keep pace with inflation. However, if you invest in assets that can yield greater returns, you have a higher risk of losses.
With a lump sum, there is no guarantee the money will last a lifetime. A regular pension payment will last until you die.
"In an environment with low fixed-income interest rates and generally expanding life expectancies, the pension stream is generally the better way to go," says Louis Kokernak CFA, CFP, founder of Haven Financial Advisors, Austin, TX. "It is no accident that private and public employers are paring back those benefits. They are trying to save money."
You also need to think about health insurance. In some cases, company-sponsored coverage stops if an employee takes the lump sum payout. If this is the case with your employer, you will need to include the extra cost of health insurance or a Medicare health supplement in your calculations.
Risks of regular pension payments vs. lump sum
One downside of pensions is that an employer could go bankrupt and find itself unable to pay retirees. If your company is in a volatile sector or has financial troubles, it may be worth taking a lump sum. But for most individuals, these are unlikely scenarios. If you have a pension plan, you should also know that it is risky to take a loan from your plan and will probably cost you more in the long term.
Keep in mind, though, that your pension benefits are safeguarded by the Pension Benefit Guaranty Corporation (PBGC), the government entity that collects insurance premiums from employers sponsoring insuredpension plans. The PBGC only covers defined-benefit plans, not defined-contribution plans like 401(k)s.
The maximum pension benefit guaranteed by the PBGC is set by law and adjusted yearly. In 2023, the maximum annual benefit is $81,000 for a straight-life annuity for a 65-year-old retiree. (The guarantee is lower for those who retire early or if the plan involves a benefit for a survivor. It is also higher for those who retire after age 65.)
As long as your pension is less than the guarantee, you can be reasonably sure your income will continue if the company goes bankrupt.
Special Considerations
Think about why your company would want to you to cash out of your pension plan. Employers have various reasons.They may use it as an incentive for older, higher-cost workers to retire early. Or they may make the offer because eliminating pension payments generates accounting gains that boost corporate income.
Furthermore, if you take the lump sum, your company will not have to pay the administrative expenses and insurance premiums on your plan.
Before choosing between a lump sum or regular pension payments, consider how companies determine the amount of lump-sum payouts.
From an actuarial standpoint, the typical recipient would receive approximately the same amount of money whether choosing the pension or the lump sum. The pension administrator calculates the commuted value using the average lifespan of retirees and adjusts the payment schedule accordingly.
That means if you enjoy a longer-than-average life, you will probably receive more money taking the lifetime payments. But if you do not expect to live as long, you may get more with the lump sum.
One approach might be to have it both ways. You could put part of a lump sum into a fixed annuity, which provides a lifetime stream of income, and invest the remainder. But if you’d rather not worry about how the market is performing, a stable pension payment might better suited for you.
What Are the Advantages of Taking a Lump Sum on Your Pension?
A lump sum pension distribution give you your entire pension at once. It offers the flexibility of being able to spend or invest your retirement savings any way you see fit. While a pension annuity offers a fixed monthly income, a lump sum can be used for a range of purposes, including for unexpected medical expenses. If you die early, you can potentially receive more money than you would with regular payments. If invested carefully, a lump sum could also offer a passive income.
What Are the Disadvantages of Taking a Lump Sum on Your Pension?
Perhaps the greatest risk of cashing out a pension early is the prospect of running out of money. With life expectancies rising, many retirees face the increasing likelihood that they may outlive their savings, especially if they spend it. Studies show that retirees who cash out their pensions are less likely to maintain the same levels of financial stability after five years. A monthly payment offers a steady income for the remainder of one's life, and in some cases can also be passed on to a spouse.
What Happens to a Pension If Your Employer Goes Bankrupt?
If an employer goes bankrupt, they may be unable to meet their pension obligations. This is rare, but the risk is higher for companies in volatile sectors. If an employer terminates a plan due to financial distress, their pension is generally covered by the Pension Benefit Guaranty Corporation, a federal agency that insures private-sector pension plans. Not all retirement plans are insured by this agency, so it is worth checking to see if your plan is protected.
The Bottom Line
For some, a lump-sum pension payment makes sense. For others, having less to upfront capital is better. In either case, pension payments should align with your personal goals for your retirement. If you're not sure which option is best for you, consider speaking with a financial advisor to see whether a lump-sum or regular payment schedule is the best strategy for you.
