Should You Take A Lump Sum Pension Distribution?
So you’re faced with a choice: take the money now or wait for your pension to kick in. What do you do?
First, let’s start with the standard disclaimer. Each situation is different and you should consult your personal financial advisor and tax accountant prior to making any decision of this magnitude. That said, let’s step through the topic in a systematic manner.
First, a bit of background information on why a company might make such an offer. With a traditional defined benefit pension plan (i.e. one that pays you an ongoing benefit in retirement), the company has to record an obligation on their balance sheet. The size of this obligation is based on a number of complex computations performed by actuaries the company retains. One of the most important factors is that of interest rates that the actuaries use. The higher the interest rate, the lower the obligation needs to be. Conversely, the lower the interest rate, the higher the obligation kept on the balance sheet needs to be. Why is this important? Well suppose that the applicable interest rates were to suddenly drop. This would significantly increase a company’s obligation; which, in turn, would require an infusion of cash in to the pension fund. Perhaps a significant increase in cash. As the old adage states, cash is king in business; and, accordingly, the company’s financial leadership is none too happy when such an event occurs. By offering a lump sum – at the prevailing interest rate – they get the obligation off the book; and, this allows reduced variability in future cash flows. Bottom line, there is a benefit to the company in doing this; and, quite possibly, there can be a benefit to you…
There are three possible ways that you can benefit by taking a lump sum versus a pension:
- You may be able to take the lump sum payment and purchase an annuity from an alternate provider that pays a bigger benefit.
- You may be able to take a series of withdrawals from the lump sum over time that will be larger than your pension payments.
- You – or I should say your heirs – may be much better off if you were to die unexpectedly (either before eligibility to draw the pension or before your expected life expectancy).
In each of the above situations, the analysis comes down to three key factors:
- Your life expectancy.
- The rate of investment return you can earn on your own.
- The variability of the investment returns you can earn during the withdrawal period.
The third of these factors is the most important and least understood. We’ll elaborate on this in just a bit.
In my opinion, the easiest way to understand a complex topic is via an example. Let’s create a fictitious employee Tom and consider his case:
- Tom is currently 50 years of age
- Tom would like to draw his pension at age 65
- Tom believes he will live to the age of 95
- Tom’s projected pension benefit is $20,000
- Tom is married to Jane, and would like to make sure Jane continues to receive his pension benefit if he dies before Jane. The company’s pension plan allows for this, BUT under this option, Tom and Jane’s pension will be reduced by 25% / will only be $15,000
- Tom feels that Jane will live exactly one day longer than him/their life expectancy should be the same
- Tom feels he can get a 7% return on his investment portfolio
- Tom has been offered a lump sum payout of $140,000
There is a link to table at the end of this article that summarizes the calculations for Tom and Jane’s situation. I would recommend either printing it or opening another copy of this post in a separate tab so you can easily refer to the values. You can open the table in another tab by clicking here.
The first thing we do is take the pension payments that Tom will receive from age 65 to 95 and discount these back – using Tom’s assumed rate of return of 7% — to a current present value. The calculation of this gives us: $72,900. In other words, Tom would currently need to have $72,900 dollars in hand if he wants to withdrawal $15,000 a year from age 65 through age 95 if Tom can earn EXACTLY 7% and have NO variability in his returns. If we believe this, then the answer is simple:
- If the lump sum value is larger than the discounted present value of Tom’s expected pension payments, Tom should take the lump sum and withdrawal from the lump sum in lieu of a pension.
This simple answer is extremely dangerous as it ignores the issue of sequence of returns that was mentioned above! Suppose that Tom is not quite as competent as he thinks he is, or he has a couple of bad years, say -30% investment return for the first two years of retirement, but makes up for this with a 44% return in years 87 and 88 of his life. On average he still makes the 7%. However, as you can see, Jane’s not going to be very happy as the account will be dry before they reach 95 years of age.
This “sequence of returns risk” forces you to take a much lower withdrawal amount to ensure that your withdrawals will last over your lifetime. As a result of the above, Tom’s actual withdrawal’s will need to be much lower than his average rate of return as Tom is essentially going to “create his own pension” with the lump sum. Accordingly, he needs to build in an appropriate “safety factor”.
How much can Tom withdrawal? While there is no guaranteed number, there is some widely accepted research that suggests that you can safely withdrawal 4% of your initial lump sum and be safe for a 30 year withdrawal period. The topic of withdrawal rates from retirement portfolios is very complex and well beyond the scope of this article. For purposes of this article, we’ll use this “4% safe withdrawal rate”. Again, consult your financial planner and tax accountant for a more thorough treatment of this topic.
Many of you will notice that this number is well below the historical, long term stock market returns. That’s EXACTLY because of the issue of variability of returns. And this is what you need to be careful of when you evaluate whether or not to take the lump sum distribution.
Turning back to Tom’s situation, we see in the table that if Tom were to take the lump sum payment, his investment account would have a value of $386K at age 65. Using the 4% safe withdrawal rate, we see that $15,400 would be a reasonable estimate of the pension he might be able to pay himself via accepting the lump sum. Hence, you can see that the two alternatives are essentially a wash if the numbers are as presented — the 4% or $15,400 he gets from the lump sum is nearly identical to the $15,000 he would get under the traditional pension.
However, the opportunity lies in what happens if Tom does NOT experience the worst possible case, but rather experiences the average case. You can see that on average he might expect to have his cake and eat it to – under the average scenario, he would draw the $15K a year pension AND end up with $1.5M in the account! This situation is why your heirs might be quite interested in having you go with the lump sum alternative; and, assuming you have other income sources or other investment assets, it’s exactly why you may want to strongly consider a lump sum pension payment.
An in depth, appropriate analysis is going to involve a number of additional factors:
- Do Tom and Jane have any additional assets that they would also be able to draw from in retirement?
- How does the maximum safe withdrawal amount from Tom and Jane’s total portfolio compare to the amount of income they will need in retirement?
- What state do Tom and Jane live in and what are the implications of pension income versus withdrawals from a 401k/IRA?
- What is Tom and Jane’s health status and what is the history of the longevity in Tom and Jane’s family?
- What are Tom and Jane’s expectations regarding inflation?
- Do Tom and Jane have any desire to leave an inheritance to their heirs?
So what’s the conclusion? Again, standard disclaimer, each situation is different and you need to consult your personal financial advisor and tax accountant. That said, here’s the rules of thumb that I use when helping people determine if a lump sum may be worth considering:
- Case 1 — You are likely better off taking a lump sum payment if:
- You have a solid investment strategy – or are working with an advisor that can help you develop such a strategy – that you have implemented and are continually monitoring, AND
- You have significant assets already accumulated (i.e. a large 401k) and expect that your asset base will be more than sufficient to fund your retirement, AND
- You have a spouse/partner who has a high probability of outliving you
- Case 2 — You are likely better off taking the lump sum payment if:
- You can purchase an immediate annuity from an external provider that has a higher payout than the pension currently being offered via the buyout. WARNING – By annuity I mean a single premium immediate annuity. Proceed with extreme caution if anyone brings up the topic of variable or equity indexed annuities.
- Case 3 — You are likely better off NOT taking the lump sum payment if:
- You are an inexperienced investor without a defined strategy, OR
- You have no other accumulated assets, OR
- You tend to believe there is a magical product available that will guarantee you will be better off taking the lump sum, OR
- You are prone to make hasty decisions regarding your finances and change directions based on what Jim Cramer advised earlier today.
I’ve attached a link to a spreadsheet that will help you to perform the quantitative calculations for your particular situation. Keep in mind that the spreadsheet is just a starting point for your analysis. The factors that I mentioned above all need to be incorporated in to your actual decision. Again, my guidance is that you reach out to your financial advisor and tax accountant to help you with this decision.
If you have any questions or concerns on this topic, you are welcome to contact me and I will be happy to help you with this important decision.
Access to Links For Easy Reference:
Table For Example in PDF Format