Whether to take a pension as a lump sum or monthly payments
Traditional pensions are increasingly rare to have. If you’re a federal, state, or municipal “public” employee, you will likely have a pension from that employer when you retire. And if you are a long-time employee of a non-public employer, you might potentially have a pension from them. But if you started working for a non-public employer within the last 20 or so years, you likely will not have a pension from them.
For those of you who will have a pension, you might have to eventually make a decision of whether you want to receive the pension in the form of monthly payments for the rest of your life, or if you’d rather receive a lump sum in lieu of lifetime payments. Or, maybe you have the choice to receive some of your pension as lifetime payments and the rest as a lump sum. Regardless, this is a major choice and you want to ensure you make the choice that’s best for you.
Notice I said “choice that’s best for you.” That’s because there generally isn’t a single quantifiable, definitive, universally “right” choice. A lot of the decision will be unique to you and your circumstances, some of which are subjective and intangible. This article will help provide some things to consider and a framework to use when making the decision between taking the monthly payments or taking the lump sum.
I’ll start the conversation by summarizing the main pros and cons of taking a lump sum. And this isn’t to say you should or shouldn’t necessarily consider the lump sum. I’m simply choosing to look at it from the perspective of taking the lump sum as opposed to taking the payments. But you can view this list of pros and cons in reverse if you want. In other words, what I’m about to list as pros of taking a lump sum can also be viewed as cons of taking the monthly payments. And vice versa.
But first I want to briefly talk about what it actually means to receive a lump sum, from a tax perspective. Generally speaking, your pension will be mostly or solely pre-tax money. Meaning it’s money you haven’t yet been taxed on and will therefore be taxed as you receive the payments going forward. With that said, if you choose to take a lump sum, that lump sum will similarly be mostly or solely pre-tax. If you outright distribute the lump sum to yourself via putting it into your bank or brokerage account, you will have to pay income tax on all of the pre-tax portion of that distribution in the year of the distribution.
As such, think about a pension lump sum kind of like a pre-tax retirement account like a 401(k) or IRA; if you simply take it out payable to yourself, it’s taxable in that year. Instead, you would typically “roll” the money into another pre-tax retirement account, thus continuing to defer the taxation of the money. You’ll then only be taxed on it whenever you eventually take it out.
For example, if you have the option to take your pension as a $500k lump sum (and we’ll assume that’s all pre-tax), you would have to pay income tax on $500k if you distributed that lump sum to your bank account. But if you instead rolled/transferred that $500k to an IRA, then that rollover or transfer isn’t taxable. You’ll only pay tax whenever you later take money out of your IRA. Such as if you take $40k out of the IRA next year; you’ll have to pay tax on that $40k next year, but the rest of the money in the IRA wouldn’t be taxable at the time.
Okay, now let’s get into it!
PROS of taking the lump sum
More flexibility – When you take the lump sum, you can do with it as you please. With the monthly payments, you’ll get $X per month, no more and no less. If there are months you want or need a bit more, you’ll have to take from other assets. With the lump sum, you’re free to take as much or as little as you want at any point. Though you’ll be subject to Required Minimum Distributions eventually. Recall what I said before about pension lump sums getting rolled into an IRA. After they’re put into an IRA, the money in the IRA is then subject to normal IRA rules, and that includes having to take Required Minimum Distributions.
An extension of the flexibility of taking the lump sum is for those who are charitably inclined. If you plan on donating cash to charities in retirement, one of the most tax-effective ways to do that is to use pre-tax IRA money to do Qualified Charitable Distributions, or QCDs, which I’ve talked about a few times before. When you roll a pension lump sum into an IRA, you can then do QCDs out of the IRA once you’re 70 ½. But if you take the monthly payments, you can’t redirect the receipt of those payments to instead go directly to charities and be treated as a QCD. Or at least, I’m not aware of any company that allows that with its pensions.
Another part of a lump sum being more flexible is the ability for you to invest the money however you want. You can put it all into cash or cash equivalents, all into stocks or stock funds, or anything in between. When taking your pension as monthly payments, you don’t have any discretion as to what to do with the money you haven’t yet received. That’s all up to the payer of the pension to figure out and do.
Likely able to produce a better financial return – Tying into the point above, if you take a lump sum you can control how that money gets invested. A well-invested lump sum could likely generate a higher financial return and therefore generate more usable income throughout your lifetime than taking the monthly payments. BUT, there is no guarantee that will be the case. And this is really what this whole lump sum vs payments decision comes down to: how much do you value the guaranteed and known outcome of taking the monthly payments vs having the potential (but not the guarantee) that you can maybe do better with the money by investing it and taking out distributions as needed throughout your life. And this is why I say a lump sum is “likely” able to produce a better financial return. It might…but it might not.
Most pensions, if taken as monthly payments, will likely end up resulting in an annualized “return” of roughly five percent, give or take a bit, if you end up living to average life expectancy. And the return will end up being a bit less if you die young, or a bit more if you live beyond life expectancy.
Whereas if you instead take the lump sum and invest it in a diversified portfolio of stocks and bonds or stock funds and bond funds, you could likely end up generating an annualized return of a bit more than that five percent-ish figure. Which means you can ultimately end up producing more usable income from the lump sum vs taking the payments. But again, there is NO guarantee that will be the case.
Can potentially leave a larger legacy – As I touched on earlier, taking the monthly payments means the payments will last as long as you do. Or, if you’re married, you might have the option to select a payment that will continue on for your spouse if you predecease them. However, once you (and your spouse, if married) pass, there is typically nothing left and no residual payments to anyone. Meaning if you have kids or anyone else you want to leave money to, there will be nothing left of the pension to leave for them after you’re gone.
If you take the lump sum, there will be something left of that to give to your heirs, assuming you don’t fully spend it down during life. Especially if you (and your spouse) die early and/or your investments selected for the lump sum do really well, the lump sum option will leave more legacy than taking the payments would, all else equal.
Can potentially keep up with inflation better – This is kind of just another point tied to the concept of a well-invested lump having the ability to potentially have better returns than taking monthly payments. Most pension payments don’t have a cost of living/inflation adjustment. Federal pensions do. Some pensions from state and municipal employers do. But most pensions from non-public employers don’t have any sort of inflation increase to them.
While a monthly pension payment of $X might be a good amount of money for you now, that same $X per month won’t go as far in twenty or thirty years after accounting for inflation between now and then. On the other hand, if you take the lump sum and invest it well (and the markets cooperate), you’ll have a better chance of not losing as much of your buying power to inflation, as your lump sum could potentially end up generating more usable money for you over your lifetime than the payments would. But again, I have to reiterate there is NO guarantee of that.
There could be more specific and less widely applicable pros to taking a lump sum above and beyond what I mentioned above. But I think I hit on the biggies here. Now let’s look at the main cons of taking a lump sum.
CONS of taking the lump sum
Can outlive it – All of the cons of taking the lump sum frankly boil down to this point. When taking the monthly pension payments, you can’t outlive them. Those payments will show up each month as long as you’re alive, even if you live well beyond 100 (though there is potential credit risk of the pension payer becoming financially strained and unable to continue to make payments for the rest of your life. See my comments later on for more of my thoughts on this issue).
On the other hand, when taking the lump sum, there is no guarantee it will last you your whole life. Whether you spend too much from it, its investments do poorly, or some combination of the two, it’s definitely possible to burn through the lump sum before you die.
Might spend it down too quickly – This is obviously just another way to say you can outlive a lump sum. But I wanted to make this its own point to give some more focus on how and why you might spend it down too quickly.
If you have spending issues (i.e. you spend more than you should), taking the lump sum could be dangerous as there won’t be any restrictions or controls on how fast you take money from it. With the traditional monthly payments, on the other hand, it sort of forces a budget on you, for lack of a better word. It doesn’t matter how much you want to go out and spend $20k on a big vacation. If you’re only getting $5k/month (for example) from your pension, you obviously need to save up a few months' worth of payments to come up with the $20k, unless you have other sources of assets from which to pull additional money to pay the $20k.
Another way you might spend down a lump sum too “quickly” is if you end up living a really long time. In this sense, “quickly” is a relative term. If you take $5k a month out of your lump sum of $300k, you aren’t going to spend it down too quickly if you die two years after taking the lump sum. But if you live forty years and keep taking out $5k per month, you’ll almost certainly deplete the lump sum before you die, because you spent it down too “quickly” relative to how long you lived. And the level of investment return you’ll need to support annual withdrawals of $60k on a lump sum of $300k simply aren’t anywhere near realistic to assume.
Investment risk – Having the flexibility to invest a lump sum could be a double-edged sword. As I mentioned above, I feel a well-invested lump sum is likely to end up producing a better financial return (i.e. more usable money) over your life than taking the monthly payments. But like I’ve said a few times already, there is no guarantee of this. If you don’t know much about investing, or if you do pick good investments but we enter a period of poor returns unlike any we’ve experienced in the past, the lump sum option could, in hindsight, end up being financially worse for you than if you instead took the monthly payments.
More onus and responsibility on you – When taking the monthly payments, you essentially don’t have to do or worry about any aspect of getting the money, making it last, investing it, etc. You simply tell the pension payer what bank account you want the payments to go to and how much tax you want withheld from each payment, and that’s about it. Then you just sit back and let the payments hit your bank account each month.
If you take the lump sum, not only are you the one who must decide how to invest it, but you also have to figure out how much to take out and when, how to operationally take money out and get it to your bank, how to apply or update tax withholdings, etc. Granted, you can hire an advisor to do most of these things for you if you don’t want to do them yourself. But that obviously comes at a cost. And hiring an advisor still doesn’t get rid of the other cons mentioned above. An advisor could help reduce the risk of some of the cons, but an advisor can’t eliminate them.
All said and done, some people might not want to have to worry about any of the responsibilities and risks in taking the lump sum, and might prefer the simplicity and guaranteed nature of taking the monthly payments.
Before moving on to the next section about how to figure out if the lump sum or monthly payments might be better for you, I should mention that taking the lump sum doesn’t necessarily mean you have to invest it and take distributions at your discretion. If you like the look and feel of getting a guaranteed-for-life monthly payment, another option is to take the lump sum and use it to buy a commercial annuity from an insurance company.
This would be, in effect, buying yourself a private pension. But instead of your former employer being the one to pay you each month, you’d be receiving your monthly payments from an insurance company. Spoiler alert though – many employers who have pensions have been getting out of the business of managing and administering their pensions. There has been a trend over the last couple of decades of companies offloading their pensions to insurance companies to invest, manage, and administer. Which means your pension might ultimately be coming from an insurance company anyway! That isn’t necessarily good or bad; it just is. But see my comments later about credit risk.
Anyway, why would you forego taking the monthly pension payments to instead take the lump sum to turn around and use it to buy yourself guaranteed monthly payments thus basically replicating what you initially opted out of??? You’d consider doing this if the lump sum could buy you higher monthly payments in a commercial annuity than what you could get if you directly took the monthly payment option from your pension. But more on that later.
Questions to ask yourself to help determine if you should lean toward the lump sum or the monthly payments
There is no slam dunk black and white objective process to definitively say whether you’ll be better off with the lump sum or payments. Like most aspects of long-term financial planning for retirement, we must make a lot of educated guesses about the future to come to the answer we think is best based on what we currently know.
This includes having to make assumptions about how long you (and your spouse, if married) might live, what returns the stock and bond markets might produce going forward, what inflation will be going forward, how your life and expenses might change going forward, how your willingness and/or ability to manage your finances and investments might change in the future, etc.
However, I came up with some questions I like to think can help narrow down your choice when deciding if you might be better off taking the lump sum or taking the monthly payments for your pension:
Question 1 – Do I want or need additional guaranteed lifetime income?
There are only three sources of income that are truly guaranteed to last for a person’s lifetime: 1) Social Security, 2) annuities, and 3) traditional pensions like we’re discussing here. You might be saying things like Social Security and/or annuities aren’t truly guaranteed, because the payer could become insolvent and/or otherwise not be able to pay you in full and on time for the rest of your life. And that’s true. And that’s a risk you have to take into account when making your decision. But that aside, outside of the payer eventually not having the financial ability to continue to pay you, the payments are guaranteed in that the payer commits to you that they will pay you $X every month for the rest of your life.
There are multiple ways to think about and analyze how much guaranteed income you might want or need. One basic approach is to project your expected expenses for the rest of your life, with a particular emphasis on how much of those expenses are going to be necessities that you will have little or no ability to do without. Things like housing, transportation, healthcare, and food, for example. And be honest and realistic when projecting these necessities. For example, housing costs for a house that’s twice the size you actually need isn’t a necessity, in my opinion. But the cost of housing for a reasonably sized place that allows you to live a dignified life without squalor or lavish excesses is a necessity.
Let’s assume your total annual expenses are projected to be $120k per year, and that $80k of those are assumed to be necessities. Further assume your other source(s) of guaranteed income will be just Social Security, which will be $50k per year when you turn it on. That means there will be another $30k of necessary expenses that wouldn’t be covered by guaranteed income. In this scenario, if you have a pension that would coincidentally pay you $30k per year if you took the monthly payments, perhaps you would go with taking the payments. That way, regardless of what happens to the rest of your investable money later in life, you know that you will have enough guaranteed income to cover the basics needed.
Obviously, this isn’t a perfect analysis, as I’m not accounting for things like inflation, where the increase in your necessary expenses might outpace the increase in your Social Security and lack of increases in your monthly pension payments. But hopefully this example at least gave some food for thought on how to start to approach determining if you might want to consider additional guaranteed income, in which case leaning toward the monthly payments could make sense.
Another way to try to see the potential long-term financial impacts of taking a lump sum vs monthly payments is to use financial planning software to model the different scenarios. In theory, having higher amounts of guaranteed income means you can take more risk with the investable assets you have. This is because more of your expenses will already be covered by guaranteed income and not subject to sequence of returns risk (i.e. your investments being down when you need to sell some to generate cash to take out to meet expenses). Basically, you would need less allocation to conservative investments since you’ll already be getting more guaranteed income every month. So then you can invest your assets more aggressively, and they can therefore have the potential to grow larger than they otherwise would have had you not taken the monthly payments and invested your assets more conservatively. While there is no guarantee this will be the case, you can at least use financial planning software to see what its fancy, crystal ball, educated guess of future market returns might possibly mean for your wealth over the long term.
Question 2 – Am I risk-averse?
Being “averse” to risk means you don’t like taking risk. Taking risk is emotionally stressful for you. Getting agita and losing sleep over seeing the balances of your investable accounts fluctuate with the markets could mean you’re risk-averse. Watching CNBC and getting heartburn over the latest negative headline could mean you’re risk-averse. Constantly dwelling on what could potentially go wrong with your investments as opposed to what could go right could mean you’re risk-averse.
The opposite of risk-averse would mean you’re comfortable taking risk. You enjoy (or at least don’t mind) watching and following the markets. You focus more on what could go right with your investments as opposed to what can go wrong with them. You are fine enough seeing declines in the stock market because you believe it will always come back and then some, and you want to be invested for when it does come back.
If you are risk-averse, leaning toward taking the monthly payments could potentially make more sense for you. The stability, guarantees, and known certainties of the monthly payments could give you much more peace of mind and comfort.
Question 3 – Am I okay leaving less to my heirs?
As I mentioned before, there is typically nothing left for heirs if you take the monthly pension payments. Other than opting to receive a payment that lasts for the life of your spouse (if you’re married) if you predecease them, there is generally no residual value or lump sum left to pass to heirs after you (and/or your spouse) die and the monthly payments stop.
For some folks, that’s completely okay as their priority is to ensure they don’t run out of money during their life; their priority isn’t ensuring there is something left for their heirs after they’re gone. But for other folks, the desire to leave a legacy might be better suited by taking the lump sum.
Though to be fair, assuming the person has other assets outside of just the lump sum they’d have if they opted to take it instead of monthly payments, taking the monthly payments would mean the person is spending down less of the other assets they have. And therefore, in theory, they might actually end up with more legacy (in those other assets) if they opt for the monthly pension payments, as it allows them to preserve more of the other assets they’d otherwise maybe have to spend to live on if they took the lump sum.
Question 4 – Do I have above-average longevity?
All else equal, the longer you live, the more money you will have to spend during your life. The benefit of a guaranteed lifetime income source (i.e. Social Security, annuity, or traditional pension) is that you can’t outlive it. Barring default of the payer, the payments will last as long as you do, even if you live to 120 or more.
If you have good reason to believe you have a high chance of living noticeably beyond the average life expectancy of mid-80s, increasing the amounts of your guaranteed lifetime income could be good “longevity insurance;” it can help ensure you can’t outlive your money. Or at least, it can ensure you will have that much more guaranteed income coming in throughout the rest of your years, regardless of how long that might be.
Actuarially speaking, most pensions payments are calculated based on the assumption that the recipient lives an average life expectancy. For example, assume you have a pension available to you and the monthly payment would be $5k. Your company came up with that figure based on the assumption that you and everyone else in their pension system will live until their mid-80s, roughly. If your company were to know for certain that everyone in their system would live to 95, the monthly payments they’d pay would be MUCH less. Because then the company knows they’ll have to make payments for about 10 more years than they were otherwise assuming.
With this said, if you have a family history of people living really long, you have no known serious medical conditions, you live an active and healthy lifestyle both physically and mentally, etc., there’s a good chance you will live beyond average life expectancy. As such, taking the monthly payments could end up being the better choice.
Though to be fair, we’ll only know for sure in hindsight, looking back after you’re gone, to compare what the total amount of payments you would have received was vs what you could have gotten had you taken the lump sum and invested it.
Again, most of retirement planning is making educated guesses about the future. We’ll only know after the fact what the best choice WOULD HAVE been.
After you’ve gone through the four questions, tally up your answers. If you answered “yes” to all four questions, you should seriously consider taking the monthly payments. If you answered “no” to all four questions, you should seriously consider taking the lump sum. If your answers were split, then the answer is more difficult and less obvious. But hopefully the questions at least give you good food for thought on how to try to approach making the decision.
Other thoughts and considerations about lump sum vs payments
Commercial annuities – Let’s assume you decide you want/need additional guaranteed income. So you’re leaning toward taking the monthly payments. However, before finalizing your decision and submitting the paperwork to start the payments, find out what your lump sum would be and shop that around to see how much monthly income that could buy you if you were to use it to buy a commercial annuity from an insurance company.
For example, assume you’re 65 and single, and the lifetime monthly payment if you took your pension would be $3k per month if you start it now. Or, if you were to take the lump sum now, it would be $500k.
You can use free websites like www.ImmediateAnnuities.com to get indicative quotes for how much monthly income you could get if you bought a lifetime annuity for $500k of initial one-time purchase.
As of the writing of this article, a 65-year-old male putting $500k into an annuity would get approximately $3,400 per month for life, starting payments now. As you can see, this would be about $400 more per month than if he took the monthly payments from his pension. As such, if this person decided he wanted more guaranteed monthly income, he’d likely be better off taking the lump sum and using it to buy a commercial annuity.
However, in my experience, the payout rates on pensions are usually a bit better than the payout rates on commercial annuities. In other words, for a given amount of lump sum, pensions generally pay out a bit more per month than annuities would. But this isn’t always the case. So be sure to check before making your decision.
Credit risk - Recall I said before that guaranteed lifetime payments (i.e. Social Security, annuities, and traditional pensions) are only as good as the financial wherewithal of the entity paying them. With that in mind, it’s important to consider the creditworthiness of the firm or entity responsible for paying your guaranteed monthly income.
With a traditional pension, the pension is either going to be from a public employer (like the federal government or a state government) or a private employer (like IBM, General Electric, Ford, etc.) With private employers, pensions are backed by a federal backstop known as the Pension Benefit Guaranty Corporation, or PBGC. Private employers who offer pensions have to pay into the PBGC to fund it. And then if/when a private employer becomes insolvent or financially strained and can no longer maintain its pension payments, the PBGC steps in to help out.
I’m admittedly not an expert on the PBGC. But I know that they don’t necessarily cover all pensions in full. I believe the larger your pension, the less of it they might insure and backstop. And the smaller your pension, the more they cover (potentially 100% of it, I believe). So while having the PBGC as a backstop for private employer pensions is nice, it’s not bulletproof. And the PBGC itself could be strained, depending on how many pensions it has to step in for. You can check www.PBGC.gov to find out more about the health or funded status of the system.
As for public employers and their pensions, they are NOT covered by the PBGC. As such, if that employer (e.g. the state of Illinois or New Jersey…and I’m naming them in particular because they are two most strained state pension systems in the country) finds itself in a position such that it can no longer pay its pensioners in full, there is a real risk that pension payments will need to be reduced.
However, for what it’s worth, public employers like the federal government or your state have the ability to raise additional revenue/income from taxes. So in theory, they can help improve their finances by increasing tax revenue. But obviously an entity or government can’t simply tax its way to prosperity. True fiscal reform and discipline will ultimately be needed. Yes, increasing taxes could be part of the solution for filling a budget hole. But it can rarely be the sole answer.
And if you go the route of taking the lump sum and buying a commercial annuity, be sure to check the creditworthiness of the insurer. Keep in mind you’re buying an IOU that could potentially last thirty or forty years. You want to help ensure the company on the other end of this agreement is going to be able to continue to pay you all the while!
There are third-party credit rating agencies, such as AM Best, that independently rate the creditworthiness of insurance companies. When buying a lifetime income annuity, be sure to stick to insurers who have ratings in the A range. That could be A++, A+, A or even A-. In my opinion, stay away from buying lifetime annuities from any insurers rated below that. That would be ratings that start with anything other than an A, such as B++, B+, B, B-, C++, C+, C, etc.
Also, there’s been a trend in the industry where private equity companies have been buying up insurance companies. While I can’t quite put my finger on it and explain specifically why this concerns me, I will say this concerns me. From what I know about my time working in alternative investments, private equity firms rarely buy companies with the focus of doing what’s best for the consumers or the long-term financial strength of the company. They instead buy companies with the shorter-term focus of how to make the company more valuable to sell and monetize the private equity firm’s investment in the company. Or, private equity firms use the long-term sticky nature of insurance company assets as another source of funds to invest in the portfolios of the private equity funds themselves. This is another way of ultimately focusing on doing what’s best for the private equity firm as opposed to doing what’s best for the consumer or the long-term financial strength of the company bought by the private equity firm. But this is all just my opinion and educated guess. Do with this view as you please.
It’s not necessarily all or none – Many employers don’t make you choose only the lump sum or only the monthly payments. You might have the option to take some of your pension as a lump sum, and some as monthly payments. This could be a good solution if you’re on the fence about making the decision. Maybe you want some more guaranteed monthly income, but don’t want to commit to taking the full amount of monthly payments. In this case, splitting the decision and doing some lump sum and some monthly payments could be the right answer for you.
Don’t make this decision in isolation – You must take a bigger picture view of your financial life when deciding whether to take the lump sum or monthly payments. Definitely don’t view the decision purely as a math break-even exercise where you try to guess how long you’re going to live and then decide based solely on that. And don’t make the decision without weighing in your other sources of guaranteed income (Social Security or annuities), the size of your investable assets relative to your expected expenses, an honest understanding of your risk tolerance, your legacy plans, etc.
Disclaimer:
None of the information provided herein is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Tenon Financial LLC does not promise or guarantee any income or particular result from your use of the information contained herein. Under no circumstances will Tenon Financial LLC be liable for any loss or damage caused by your reliance on the information contained herein. It is your responsibility to evaluate any information, opinion, or other content contained.