LUMP SUM OR PENSION? ??

For those of you who have earned a pension and are nearing retirement, congratulations! ?? You’ve spent dozens of years working toward retirement and carefully planning for your golden years. You decided on the date and notified the company. Maybe you even booked a celebratory vacation ???. Now comes the hard part—one of the biggest decisions of your life. Do you take the pension or the lump sum payout? ??

In the “olden” days, people would go to work for a company, stay there for 30 years, and retire with a nice monthly pension ??. Gone are the good old days. While there are still many companies that offer pensions in the traditional sense, more and more are offering the choice of a lump sum of money instead of monthly payments. ??

Companies Want Out of the Pension Business ?? There are several reasons lump sum payouts are more attractive to companies than pensions. A lump sum could be offered as an incentive for older workers to retire early since older workers tend to have higher salaries and are more expensive to the company than a younger employee with less experience. ?????? Company pensions are also expensive to administer. In its simplest form, a pension is a promise the employer makes to pay the employee a certain amount of monthly income for the rest of their life—and possibly their spouse’s life. That could add up to a lot of money, depending on how long the employee lives and the amount of the pension being paid. ??

To make these scheduled payments, companies need to invest their money, just like individuals do. With interest rates so low, employers now have to either increase their contributions to the pension plan or invest in riskier assets in an attempt to achieve higher returns. For these reasons, and others, companies are opting out of the pension business to save money and mitigate risk. ??

When a company offers a pension, the risk is squarely on the shoulders of the company.

Those risks include:

• Increasing life expectancies ??? For an individual born in the 1930s, the average life expectancy was only 58 years old for men and 62 years old for women. Fast forward to 2022, and according to the Social Security Administration, a man turning 65 today will live to be 84.1 years old and a woman can expect to live to be 86.7, on average. ?? For a couple at age 65, at least one person statistically will survive to age 93. That is a very long time for a company to pay out a monthly benefit. They could be on the hook for 30 or 40 years, which means the company theoretically could pay out more money than was contributed to the pension fund during the employee’s working years. ?
• Investment risk ?? A pension fund is a pool of the employer’s money for the worker’s future benefit. To meet its pension obligations, companies must invest these funds wisely. In the past, with high interest rates, it was easier for companies to earn the returns needed to keep the pension funded. But with low interest rates today, pension managers must invest in riskier assets for higher returns. Unfortunately, most investments carry risk. If these investments underperform or incur losses, the pension may be unable to meet future obligations. ??
• Actuarial risk ?? When designing and managing a pension plan, certain assumptions are made to forecast future needs and risks. Pension plans rely on actuaries to assess financial consequences, risks, and the likelihood of future events affecting the plan’s assets. What happens when reality doesn’t match the assumptions? Inflation is a perfect example because it’s at a 40-year high. Changing demographics are another example—many workers today are opting to work longer than previous generations. If these factors weren’t properly accounted for, the pension plan could become underfunded and unable to pay its future benefits. ??

Lump Sums Offer Several Unique Benefits and Challenges ?? When an individual takes a lump sum payout instead of a pension, the company shifts the risk to the employee. The individual now has the responsibility to invest and manage that money to keep pace with inflation, handle stock market fluctuations, and ensure the money lasts as long as they live. But with risk can come rewards. Let’s look at some of the benefits of taking a lump sum:

• Control ?? By opting for the cash payout of a lump sum, you take control of your money. The individual now has the responsibility to invest and manage it, rather than the employer. ??
• Access to Principal ?? With a lump sum, you have access to the full amount of money and can withdraw as much as you need. But when you receive a regularly scheduled pension, you forfeit access to the principal. If you need more money for an emergency, for example, you can’t withdraw it from a pension. ??
• Ability to Decide How the Money is Invested ?? A lump sum can be rolled into an IRA (Individual Retirement Arrangement) to maintain its tax advantages, deferring taxes until the money is withdrawn. This gives you the control to decide how the money is invested. ??
• Ability to Leave Assets to Loved Ones or a Favorite Charity ?? One of the most important factors in deciding which option is right for you is how much you value leaving money to your loved ones. One worry with a pension is that if you and your spouse are both hit by a proverbial bus three years into retirement, there may be no money left for your children or loved ones. ?? But with a lump sum, you can name beneficiaries for your IRA. In the event of your death, they will receive whatever money remains in the account. ??
• Protection Against Termination of the Pension Plan or Sale of the Employer ??? A pension plan is a promise from the employer to pay a certain amount of money for as long as the employee lives. Unfortunately, some pension plans have failed, and when this happens, the Pension Benefit Guaranty Corporation (PBGC) steps in to cover basic benefits earned before the plan’s termination. However, the PBGC may not cover the full pension, and there could be disruptions to regular payments. Taking a lump sum can protect you against the financial health risks of your company. ??

Once the pension administrator pays you the lump sum, you are responsible for managing that money to provide lifetime income for you (and possibly your spouse). That one lump sum may need to last for 30-40 years of living expenses. With increasing life expectancies and medical advances, the challenge becomes even greater. ?? And if you’re a conservative investor, it may be tough to ensure that your investments outpace inflation over such a long time. You could face significant market losses or volatility. ?? Remember when COVID hit in 2020? If such losses happen, how do you continue to take income without depleting your assets too quickly? Or worse, what if you outlive your money? ?

Determining Which is Best for You ?? Determining which option is right for you is not easy, and there is no one-size-fits-all answer. Your decision depends on many factors and your unique set of circumstances. The two most important factors in this decision are your health and life expectancy. ??

• Health and Life Expectancy ?? If you are young and in good health, the pension may be the better option since you could live many years and collect the pension for a longer period. But if your health is not good and you don’t expect to live long, the lump sum might be more valuable to you. ??
• Spouse’s Health and Retirement Income ?? Also, consider your spouse’s health. If your spouse is much older than you, the pension option may not be ideal. Does your spouse have a pension of their own? If so, that may make the lump sum more attractive. ??
• Other Sources of Guaranteed Income ?? If the pension is your only guaranteed source of income, you probably shouldn’t take the lump sum. But if you (or your spouse) have other reliable income sources, like rental income or another pension, the lump sum may make more sense. ??
• How Much Time You Want to Spend Managing the Money ? A pension doesn’t require ongoing management. But if you take the lump sum, you’re responsible for managing it. If you’re comfortable managing your investments and have the time to devote to it, a lump sum gives you more control. ??

Run the Numbers ?? One of the best numbers to calculate is the Pension Income Ratio (PIR). This is the percentage of income that your lump sum pension provides. Here’s an example:

Suppose your pension annuity is $30,000, but the lump sum option is $450,000. The PIR is 6.67%. This means that to get the same amount of income from the lump sum, you’d need to withdraw 6.67% of the lump sum each year.

Why is this calculation important? It’s crucial because the higher the withdrawal rate, the harder it is for the lump sum to provide enough income for the long term. ??

Let’s Dig a Little Deeper ?? Imagine a glass of water. If you drink large sips, your cup will empty quickly. But if you take smaller sips, the water lasts longer. This is the same with money—if you withdraw too much too quickly, you risk running out of money. ??

Retirees often turn to the "4% Rule," which suggests that a retiree can safely withdraw 4% of their lump sum annually (adjusted for inflation) without running out of money for 30 years. For example, a $450,000 lump sum would provide about $18,000 per year at 4%—that’s much less than the $30,000 pension. This is a critical consideration. ??

Get Professional Advice ?? This is an important decision, and you should take the time to carefully analyze your options. Consult a financial adviser who is a fiduciary and legally required to act in your best interests. While it’s tempting to make the decision on your own, this is a big enough decision to warrant the help of someone who has the expertise to guide you. ????

An experienced adviser will focus on more than just the numbers. They’ll take the time to understand your values and goals and create a retirement plan that aligns with your needs. ??

At the end of the day, you’ve worked hard for decades—make sure you make the right decision to enjoy your retirement. ??