Should I Take a $150,000 Lump Sum or $1,200 Monthly Payments for My Pension?

When companies offer a pension, it's common to give retirees two options: collect the pension as a lifetime monthly payment or receive it as a lump sum at retirement. 

Monthly payments over time are the format that most people associate with pensions. However, a lump sum payment can, sometimes, be the better option. Depending on what your company offers and what kind of returns you can pursue, you might collect more from your money in the long run by taking it all up front.

For example, say that you're an individual getting ready for retirement. Your employer has offered you either a $150,000 lump sum or $1,200 monthly payments for life. Here's how to think about it.

To speak to a professional about your own retirement options, you can get matched with a fiduciary financial advisor for free.

How Do Pensions Work?

Pensions are otherwise known as "defined benefit retirement plans." This means that your employer commits to providing certain benefits in retirement. This is as opposed to "defined contribution retirement plans," through which your employer commits to providing certain contributions during employment.

With a pension, your employer promises to provide monthly payments throughout your retirement. The exact amount can range widely, and is typically determined by factors that include your age, salary history, tenure with the company and seniority at retirement. This amount may be indexed to inflation or, like an annuity, it might be fixed.

It is the employer's responsibility to keep the pension funded and solvent throughout eligible former employees' lifetimes. To ensure that this system functions, pensions are backstopped by a federal agency which insures pensions up to a maximum amount.

Managing The Costs of Pensions

Pensions are popular among workers and retirees because of their reliability. You don't have to worry about balancing savings against costs of living. Nor do you need to manage complex, unpredictable and (if, you go it alone, very mixed) market returns. Instead, you can simply retire with an income. 

For this same reason, however, pensions have become unpopular among employers. The same reliability that makes pensions valuable for retirees creates high and indefinite costs for companies. The expense of caring for a former workforce, quite simply, is very expensive.

As a result, among employers that do offer a pension, it's common to offer "lump sum distributions." With a lump sum distribution, the employee receives a single payout at retirement instead of monthly payments for life. This can turn an indefinite series of payments into one, scheduled expense, which is much more manageable for the employer.

Should You Take A Lump Sum or Monthly Payments?

As an employee, though, which is in your best interest?

For example, say that your employer has offered you two options. You can take $1,200 per month for the rest of your life, or you can collect a $150,000 lump sum payout. Which should you take?

The answer here depends on a lot of factors, including how the math breaks down.

Reliability

If you are seeking reliability, take the monthly payment. As discussed below, under the right circumstances you might get more money from the lump sum payment, but that will depend on market returns and there's an element of risk to any investments. If you take the monthly pension, your payments are mostly secure and your budgeting and investing needs may be simpler.

Total Income

If, instead, you're trying to maximize your retirement income the right choice will depend a lot on your assumptions and your projected investment outcomes.

An investor looking for safer investments, generally in the bond market, will probably make more money taking the monthly payments. However an investor who can successfully manage a more aggressive position, perhaps with a mixed portfolio or an S&P 500 index fund, will probably make more with the lump sum.

To understand this, let's assume that you retire at age 67 and have the average life expectancy of around 85. And let's assume that your pension is fixed, with no inflation adjustments. Using Schwab's pension calculator, you would need to invest your $150,000 at a 7.03% rate of return just to match the income of your $1,200 monthly payments over your life expectancy.

This means that you would need a reliable return of around 8% in order to make the lump sum payment meaningfully more valuable than the monthly payments and still be able to use some it in the meantime. This is certainly possible. In fact, 8% is about in line with the average return on a mixed bond/equities portfolio. And if you have the flexibility to manage volatility, you could do even better with a pure S&P 500 fund's average 10% to 11% returns. 

But it would mean managing the volatility and risk that comes with equity investment. In particular, you would need a plan for income during down years so that sequence risk doesn't erode the value of your portfolio. For this reason, retirees prefer to shift their investments toward security in retirement. This tends to lean toward bond-heavy portfolios, which generally issue returns between 4% and 6%. In that case, the $1,200 monthly payment would likely provide both better security and more income.

A fiduciary financial advisor can help you do the math in your personal situation. Get matched with up to three advisors for free.

Inflation

A quiet headline here is inflation, because it can cut both ways.

Many pensions are indexed for at least some degree of inflation, known as a "cost of living adjustment." They might use the same process as Social Security, issuing an actual inflation-adjustment each year, or they might simply increase payments by a flat percentage.

In this case, with a starting payment of $1,200 per month, let's say that your employer has a simple benchmark inflation index. They increase your pension by 2% each year to keep it in line with the Federal Reserve's target rate.

In that case, again based on Schwab's calculator, you would need to invest your $150,000 at a minimum 9.03% return just to generate the same income as your monthly pension. You would need a reliable 10% rate of return to significantly beat that $1,200-indexed payment. 

Now, again, this is possible. Ten percent is roughly the S&P 500's average annual rate of return. However, you would need to keep your money entirely in equities, which means managing the volatility of market dips and rushes. 

This is fine during your working life, when you can simply leave that money alone to ride out a bear market. (Which is exactly what you should do. Ignore all of the very bad financial advice suggesting that you have "lost" money from your 401(k) during a downturn.) In retirement it's a different story. Since managing sequence risk is far more difficult when you rely on this money for income, most households would generally get more money and security by taking the $1,200 per month.

On the other hand, say that your monthly pension has no inflation index. In that case, you will receive a fixed $1,200 per month. This will expose your income to inflation risks in a way that taking the lump sum will not. With the lump sum, you are more likely to receive inflation-indexed growth. This will help protect your household from creeping costs, although again at the expense of needing fairly significant returns to keep up with the lost pension income. 

A financial advisor can help you understand the implications of your employer’s specific pension plan. Talk to a financial advisor today.

The Bottom Line

If your employer offers a pension, they will frequently give you two options: a lifetime of monthly payments or a lump-sum at retirement. Seek good financial advice as you choose between those two options, because the correct answer will depend a lot on your approach to investment and your personal situation.

Tips On Building A Private Pension

Photo credit: ©iStock.com/fizkes

The post Should I Take a $150,000 Lump Sum or $1,200 Monthly Payments for My Pension? appeared first on SmartReads by SmartAsset.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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