Does Taking a Pension Lump Sum Make Sense?

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For those of you retiring who are fortunate enough to be covered by a defined benefit pension plan, one of the decisions you may be faced with is whether to take your benefit as a series of monthly payments (an annuity) or as a lump-sum distribution.

Some of you who previously worked for an employer with a pension plan might also find yourself faced with a similar decision to make. A number of companies will periodically ask former employees to take a pension buyout. Either an annuity will be administered by a third-party, such as an insurance company, or former employees will be asked to immediately take a lump sum. Note that with some changes in the way payouts will be calculated starting in 2017, these buyouts might become less common.

When discussing the lump-sum option in this article, we are assuming that the lump sum would be rolled over to an IRA account in order to preserve the tax-deferred nature of the money.

Lump Sum vs. Annuity

Regardless of whether you are retiring or considering a buyout offer, the question of whether to take your benefit as an annuity or a lump sum can be complicated.

Some of the factors to consider in making this decision include:

  • What other retirement assets do you have?

    • 401(k) and similar retirement plans
    • Taxable investments
    • Interest in a business
  • Will you be eligible for Social Security?
  • Are you covered by another pension?
  • Will the payments from this pension include the potential for a cost-of-living increase if you annuitize? Note: This is rare with a pension from a private sector employer and more common with a pension from the public sector.
  • Are you comfortable with managing a lump sum and/or do you work with a financial advisor in whom you trust?
  • What is your current tax situation and what are your expectations for the future?

Factors Favoring an Annuity

A stream of annuity payments can offer a buffer against future stock market declines. Pension payments are an obligation of your employer. If a private sector firm defaults on this obligation, they can be driven to bankruptcy.

If you are uncomfortable investing a lump-sum distribution on your own, an annuity might be the better alternative. If you are already working with a trusted financial advisor, the lump sum might be a good option. However, many financial advisors look for opportunities to “snag” clients in line for a big retirement plan rollover.

Some of these advisors are excellent and truly put their clients’ interests first. There are other cases of predatory rollovers where unscrupulous financial advisors have put their clients in some very questionable investments. Hopefully, the new Department of Labor fiduciary rules will curtail most of these questionable rollovers.

Taking the annuity option might make sense if you have a sizable nest egg comprised of other accounts for retirement, such as a 401(k), IRAs and others. The annuity can be viewed as another form of diversification. The monthly payments are sometimes counted as another form of fixed income by some financial advisors. This can allow you to allocate more of your portfolio to stocks in retirement and still keep your downside risk level in line.

Factors Against the Annuity Option

If your employer was a private sector company, it is unlikely that there is any cost-of-living adjustment to potentially offset inflation. Depending upon your overall situation, this may or may not be a reason to shy away from annuitizing, but it is something to consider.

If your former employer is in the private sector and gets into financial trouble, some of your payments could be at risk. The Pension Benefit Guaranty Corporation (PBGC) is a governmental unit that is the backstop for private employers who default on their pension obligations. These employers pay an annual insurance premium to the PBGC.

However, there is a limit to the level of monthly benefit that the PBGC will cover. If you were a high earner with a large monthly benefit, you could find yourself receiving a reduced benefit compared to the one you had earned under your employer’s pension formula.

Pension payments will not allow you to leave an inheritance, if that is your desire. Once you (and your spouse, if you are married and choose a joint and survivor option) die, the benefit payments stop. Unlike with an account like an IRA, there is no possibility of passing any money left in the account to your heirs upon your death.

Lump Sum Pros

If you are an experienced investor or you work with a trusted financial advisor, then you might be able to do better with a lump sum rolled over to an IRA than by collecting a stream of monthly payments.

You can leave any money left in your IRA to your heirs by naming them as beneficiaries. Additionally, you are left with more options, such as the ability to convert some or all of the money to a Roth IRA.

If your monthly pension is over the PBGC limits but take the lump sum, you do not have to worry if your former employer gets into financial difficulties.

Overall you have greater flexibility in terms of your financial planning. For example, those who are still working past age 70½ can roll over the 401(k) of their current employer (if allowed) to an IRA via a lump sum, in order to avoid taking required minimum distributions on that money while still working.

Lump Sum Cons

The major con to taking a lump-sum from your pension is that, when invested, this money will be subject to the ups and downs of the stock market.

Summary

For those of you who are fortunate enough to be covered by a defined benefit pension, you may be offered the option to choose between a traditional monthly annuity and a lump-sum payment that can be rolled over to an IRA. There are pros and cons to both options, so it is wise to fully examine both in making your decision.

Roger Wohlner

Roger Wohlner is an experienced financial advisor, finance blogger and freelance writer based in Arlington Heights, Ill. His expertise includes providing financial planning and investment advice to individual clients, 401(k) plan sponsors, foundations and endowments. Roger contributes to his own popular finance blog, The Chicago Financial Planner, where he writes about issues concerning financial planning, investments and retirement plans. His work has been featured on Investopedia, Go Banking Rates, US News & World Report, Yahoo! Finance, Equifax Finance Blog and other publications. You can follow Roger on: Twitter - LinkedIn

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