Should I Take My Pension as a Lump Sum?

Written By: Brian Ellenbecker, CFP®, EA, CPWA®, CIMA®, CLTC®

The popularity of pensions as an employer retirement benefit has fallen over the past 50 years. According to the Bureau of Labor Statistics, 35% of private companies offered pensions in the early 90s, but only 15% of private employers offered them as of 2022. 86% of government employees still have access to a pension. While pensions are less common, they are still accessible to a significant portion of the population.

If you’re one of the lucky ones that still has access to a pension, a question you will likely have as retirement approaches is how to choose between the pension distribution options. Most pensions have multiple distribution options available, including various monthly income options and some offer a lump sum payment. As you approach retirement, we recommend reaching out to your employer benefits’ department to get a breakdown of each distribution option and the estimated value of each payout option. Once you have that information, you can start to ponder the question “how do you know whether or not you should take the lump sum option if it’s offered?”.

In simplest terms, the choice comes down to which option you think will give you the best deal. To make that determination, some assumptions need to be made.

Life Expectancy

Perhaps the most important variable in deciding whether to take the lump sum payout option is also the great unknown: how long do you expect to live? Estimating your life expectancy creates a time frame to help you calculate a breakeven point. In this regard, a lump sum is typically the best option if you think your life expectancy will be average to shorter-than-average. The monthly annuity payment tends to become a better option the longer you live. It can offer a guaranteed income stream for as long as you expect to live. With the lump sum option, depending on the rate of return you’re able to earn, coupled with your withdrawal needs, it may or may not last your entire life.

Health of Pension Plan

Another important consideration is the financial wellbeing of your former employer and more specifically the health of the pension fund. If the pension is well funded, you have less to worry about than one that is underfunded. What constitutes a well-funded plan? A generally accepted rule of thumb among actuaries is the plan is on relatively solid ground if the funding ratio is 80% or greater. However, that is only one factor to consider if the plan is healthy. You should also consider the size of the pension obligation, the plan sponsor’s financial health, and the plan’s contribution policy and investment strategy, among other things. By taking a lump sum, the funds are distributed from the pension plan and in your control. They are no longer subject to the financial risks of the company or pension plan.

Investment Risks

How comfortable are you with investing and the risks associated with doing so? If you take a lump sum distribution, presumably some or all of that will be invested until you need the funds later on. Are you comfortable with the risks and fluctuations that investors typically experience investing in stocks, bonds, and other securities? If so, then taking the lump sum might be the option to choose. If you’d rather put the investment risk on someone else (in this case, the pension plan), taking the monthly annuity payment might be a more suitable option.

Access to Funds

Would you like to have access to the funds at any time for any reason? If so, a lump sum distribution might be the best choice. If you choose a lump sum, those funds are typically rolled into your IRA. If you are 59.5, you can take distributions from the IRA for any reason without penalty. You will owe ordinary income tax on any distributions taken, but you can take as much or as little as you want at any point.  Once you reach required minimum distribution (RMD) age, which is 73 (75 if you were born in 1960 or later) for current retirees. With the monthly annuity option, you will receive a fixed amount each month.  You will not have an option of receiving more or less at any point—that monthly payment is locked in once the pension starts. This can be good if you want a predictable stream of income, but if you want more flexibility, a lump sum could be a better choice.

Calculating Rate of Return

Pension plans can choose to make either the monthly annuity or lump sum option more attractive based on the formulas they use to calculate each benefit. In other words, they may be trying to incentivize you to take one option over the other. One way to measure the relative attractiveness of the lump sum option is to calculate the rate of return you’d need to earn on that lump sum to produce the equivalent annuity income stream. If the rate of return calculated is below what you’d expect to earn on your investments, then the lump sum is a more attractive option. If the rate of return calculated is higher, then the monthly annuity may be the better option.

Planning Resource: There are tools available to help you make this calculation. My favorite is the Pension vs. Lump Sum Payout Calculator available at Dinkytown.net. It will calculate the required return on the lump sum at various life expectancies. You can also compare different monthly payment options to the lump sum.

Legacy Planning

When deciding whether to take a lump sum or monthly annuity, you also want to consider your legacy goals. Do you have plans to leave money to heirs or charity? Any amounts remaining from the lump sum distribution can be passed on to your beneficiaries after you pass away. If you choose a monthly annuity option, there is no lump sum to pass on. If you are married and chose a payment option that includes a survivor’s benefit, the payment will continue to your spouse at the chosen percentage until the surviving spouse passes away. If you chose a term-certain option, you can designate beneficiaries beyond your spouse to receive payments if you die prior to reaching the end of the term. Either of those options are more limiting than the lump sum, though.

The decision to choose a lump sum distribution option from your pension is important with many of factors to consider. If you’d like to discuss how that decision impacts your financial situation, reach out to your Shakespeare Financial Advisor to review your options and determine which one will work best for you.