Pension Decisions: Lump Sum vs. Payments for LifeSubmitted by Reby Advisors | Certified Financial Planners | Danbury, CT on August 27th, 2015
To receive your pension as a lump sum or as payments for the remainder of your life, that is the question.
The right answer for you depends on a number of factors, such as your overall financial situation, your need for certainty or flexibility, and the impact on your taxes. Factors such as your marital status, age, and health also play a major role.
When making the pension decision – as with many other personal financial decisions – you’re almost always making a tradeoff between certainty and flexibility. Most people like both certainty and flexibility, but you can usually only get more of one by accepting less of the other.
Taking a lump sum gives you financial flexibility.
In short, the main advantage of taking a pension as a lump sum is that it gives you flexibility. The money can be used to make a major purchase, pay off debt, invest in yourself to produce retirement income, or any combination of these.
Payments for life gives you income certainty.
Conversely, the primary advantage of taking a pension as payments for life is the high degree of certainty that comes with steady income. Steady income takes stress out of the golden years, especially for people who aren't experienced investors. A lump sum means taking responsibility for investing the money, and being tempted to spend it all now.
Now, let’s dive deeper and explore how the big pension decision affects your financial health in retirement:
Taking payments for life reduces longevity risk.
Longevity risk is the chance that you will outlive your income and assets.
Taking your pension as a lump sum shifts longevity risk from your employer to yourself. If you outlive your assets – because you or your spouse live longer than you expected, your investments performed poorly, or you exceeded your “spending speed limit” – your standard of living and quality of life could suffer.
Taking your pension as payments for life generally reduces longevity risk – because most pensions continue paying you and/or your spouse for the rest of your life. The company making your pension payments should be protected by the Pension Benefits Guarantee Corp., although that doesn't guarantee you'll receive 100% of the money you thought you would.
Do you need more income certainty or financial flexibility?
Income certainty is great until life changes unexpectedly. Your expenses go up. Medicare costs rise. You want an expensive vacation. Inflation. All of a sudden the certain income from guaranteed pension payments doesn't seem like such a good thing anymore. You’d like more liquid assets now and you would be willing to reduce guaranteed future income in exchange.
A lump-sum payout can be rolled it into an IRA, a portion of it buying an "immediate annuity" from an insurance company--paying you a guaranteed income as soon as you buy it (guarantees are made against the claims paying ability of the insurer). This way you essentially create the same sort of income stream you would have had with monthly payouts from your pension, but with the added advantage of having some money set aside that you can use it when you want to. [Money]
It’s always great to have this flexibility but…
Greater income certainty reduces behavioral risk.
Behavioral risk is one of the most significant financial risks to retirees. What this means is that your behavior as an investor or as a consumer can ruin your retirement and derail your lifestyle.
This is true even among sophisticated, financially savvy investors: when you no longer have a steady paycheck to rely on, the ups and downs of the market can be an emotional roller coaster and interfere with your ability to make objective long-term investment decisions.
The best example of destructive behavioral investing is selling stocks right after a crash.
In 2008 and 2009, many people hurt their financial futures by abandoning a sound investment strategy because of fear that their investments would never regain value. Their behavior – not their initial investments – harmed their long-term financial outlook. Had they stuck with a sound investment strategy and held onto their investments through the market turmoil, they would have seen their investments regain value over the next few years.
What does behavioral risk have to do with your pension decision?
In retirement, having a steady, predictable stream of income makes it much easier to stick with a sound investment strategy despite market volatility. So, taking your pension as payments for life generally reduces behavioral risk.
Consider your overall financial and personal situation.
As the pension decision boils down to the benefits of certainty versus flexibility, your overall financial picture has to be considered.
How much guaranteed Social Security income will you receive? Does this give you enough income certainty? For most people, it does not.
How much money do you have in 401(k), IRA, and non-qualified accounts? These accounts may give you the flexibility that you need, potentially making payments for life the more attractive option for you.
Do you want to leave a legacy for your children? How will you provide this – by taking a lump sum and saving it? By collecting payments for life and using it to buy insurance?
Are you in good health or poor health? Do people in your family tend to live long lives? The longer you live, the more lucrative the payments for life become. If you have an uncertain future, the lump sum may be the better option for you, your spouse, and your heirs.
Consider the tax impact of each option.
Taking a pension as a lump sum will likely result in higher taxes now, although if you don’t plan to spend the money right now it can be invested and gain value untaxed (until it’s time to sell, when long-term capital gains apply). In addition, you may be able to rollover your lump sum to an IRA and avoid immediate taxation.
Take your pension as payments, and those incremental payments not only get taxed but also may impact your tax bracket. This causes you to pay more in taxes on nearly all of your sources of income.
This is a complicated decision that impacts the rest of your life. Get professional advice!
A GAO report concluded that although pension plan sponsors do disclose information to plan participants, the decision of which pension option will work best for you requires more information and guidance than what most people get:
“Sponsors’ disclosures to participants are required to include information on the need for spousal consent, the tax implications of taking a lump sum, and the relative value of the lump sum compared with the plan’s benefits. However, this information, even when provided as required, may not be sufficient to enable participants to make an informed decision.”
So, if you’re lucky enough to have a pension and face this decision, don’t do it alone. In most cases, you cannot change your mind after the fact. Sit down with an advisor you trust, assess each option within the context of your entire financial picture, and then make a decision you feel confident about.
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