Taking a lump sum or monthly payments depends on:
- Your retirement income and essential expenses
- Your life expectancy
- Wealth transfer plans
Faced with mounting pension costs and greater volatility, companies are increasingly offering their current and former employees a critical choice: Take a lump-sum payment now or hold on to their pension plan.
"Companies are offering these buyouts as a way to shrink the size of future pension obligations, which ultimately reduces the impact of that pension plan on the company's financials," says John Beck, senior vice president for benefits consulting at Fidelity Investments. "From an employee's perspective, the decision comes down to a trade-off between an income stream and a pile of money that's made available to him or her today."
Pension buyouts can be offered to any current or former employee of a firm. You may have a vested benefit from a former employer, or your current company may be offering you a pension lump-sum buyout long before you retire.
Whatever the case, here's how a pension lump-sum payment offer typically works: Your employer issues a notice that, by a certain date, eligible employees must decide whether to exchange a monthly benefit payment in the future for a one-time lump-sum payment. If you opt for the lump sum, you or an eligible tax-qualified plan such as an IRA will most likely receive a check or IRA rollover from the company's pension fund for that amount, and the company's pension (or defined benefit) obligation to you will end. Alternatively, if you opt to keep your monthly benefits, nothing will change, except that the option to take a lump sum may be removed after the offer period expires.
The process is relatively simple, but the decision about which option to take can be complex. Here are some considerations for each option:
Keeping the monthly payment
Pension plans typically provide for the payment of a set amount every month from your retirement date for the rest of your life ("an annuity"). You may also choose to receive lifetime payments that continue to your spouse after your death.1
These monthly payments do have drawbacks, however:
- If you're no longer working for the company making the offer, your benefit amount typically will not increase between now and your retirement date. Furthermore, once you begin receiving life annuity payments, your payment amount typically will not come with inflation protection. As a result, your monthly benefits are likely to lose purchasing power over time. An annual inflation rate of 3%, the average since 1926, will cut the value of your benefit in half in 24 years.
- Taking your pension benefit as a life annuity means your ability to collect your payments depends in part on your company's ability to make them. If your company retains the pension and can't make the payments, a federal agency called the Pension Benefit Guaranty Corporation (PBGC) will pay a portion of them up to a legally defined limit. The maximum benefit guaranteed by the PBGC in 2017 is $5,369 per month (straight-life annuity) for most people retiring at age 65. The monthly guarantee is lower for retirees before age 65 and larger for those retiring after age 65. If responsibility for your payments shifts to an insurance company, it will be the insurance company and not the pension plan that is responsible for your guarantees.2
Some employers are also considering buying annuities for those who do not opt for the lump-sum offer. In this case, your benefits will not change, except that the insurance company's name will be on the checks you receive in retirement, and the guaranteed income will be provided by the insurance company.3 (As with offering lump sums, companies that transfer the annuities to an insurance company can remove the pension liability from their books.)
Taking the lump-sum payment
A lump-sum payment may seem attractive. You give up the right to receive future monthly benefit payments in exchange for a cash-out payment now—typically, the actuarial net present value of your age-65 benefit, discounted to today. Taking the money up front gives you flexibility. You can invest it yourself, and if you have assets remaining at the time of your death, you can leave them to your heirs.
However, keep in mind the following cautionary factors:
- You are responsible for making the funds last throughout your retirement.
- Your investments may be subject to market fluctuation, which could increase or reduce the value of your assets and the income you can generate from them.
- The amount of a lump sum payment has an inverse relationship to interest rates—in general, as interest rates rise, lump sum values will decline.
- If you don't roll the proceeds directly into an IRA or an employer-qualified plan like a 401(k) or a 403(b), the distribution will be taxed as ordinary income and may push you into a higher tax bracket. If you take the distribution before age 59½, you may also owe a 10% early withdrawal tax penalty.
- You can use some or all of the lump sum to purchase an annuity—typically, an immediate annuity—which could provide a monthly income stream as well as inflation protection or other optional features built into the cost. But as an individual buyer, you may not be able to negotiate as good a deal with the insurance provider as the benefit you would have received by taking the pension plan annuity, so the annuity may or may not replicate the monthly pension payment you would have received from your employer. You also need to select your annuity provider carefully, paying special attention to a company's credit ratings, and make sure you read and understand the terms and conditions of the annuity.
Making your choice
Whether it's best to take a lump sum or keep your pension depends on your personal circumstances. You'll need to assess a number of factors, including those mentioned above and the following:
- Your retirement income and essential expenses. Guaranteed income, like Social Security, a pension, and fixed annuities, simply means something that you can count on every month or year and that doesn't vary with market and investment returns. If your guaranteed retirement income (including your income from the pension plan) and your essential expenses (such as food, housing, and health insurance) are roughly equivalent, the best choice may be to keep the monthly payments, because they play a critical role in meeting your essential retirement income needs. If your guaranteed income exceeds your essential expenses, you might consider taking the lump sum. You can use a portion of it to cover your monthly expenses, and invest the rest for growth.
These comparisons may be relatively easy if you're already retired, but developing an accurate picture of your retirement income and expenses can be difficult if you're still working. Beware of the temptation to use the lump sum to pay down credit card debt or handle other current expenses—and not just because of the large tax bill you're likely to face. "Lump-sum distributions come from a pool of money that is intended specifically for retirement," explains Beck. "To access those funds for another reason puts the quality of your retirement at risk."
- Longevity. Both your monthly benefit payment and the lump-sum amount were calculated using actuarial calculations that take into account your current age, mortality tables, and interest rates set forth by the IRS. But these estimates don't take into account your personal health history or the longevity of your parents, grandparents, or siblings. If you expect to have an above-average life span, you may want the predictability of regular payments. Having a payment stream that is guaranteed to last throughout your lifetime can be comforting. However, if you expect to have a shorter-than-average life span because of personal reasons like your family medical history, the lump sum could be more beneficial.
- Wealth transfer plans. After you've considered retirement income and expenses, and have planned an adequate cushion for inflation, longevity, and investment risk, it's appropriate to take wealth transfer plans into consideration. With pension plans, you often don't have the ability to transfer the benefit to children or grandchildren. Please consult an estate planning attorney.
A pension buyout should be evaluated within the context of your overall retirement picture. If you are presented with this option, consult an expert who can give you unbiased advice about your choices. Finally, be aware that more corporations continue to consider discharging their pension obligations, so it's a good idea to stay in touch with old employers. "If you've left a pension behind at a former employer, sometime in the coming years, you're very likely to be offered a lump sum," says Beck. "Keep your former employer's administrator up to date on your current address, because you can miss this opportunity if your employer can't find you."
- First and foremost, make sure you know whether you have any pension benefit at your current or former employers, and keep your contact information with those companies up to date. You cannot even consider an offer if you don't know it exists.
- Get a comprehensive view of your retirement plan with our Planning & Guidance Center, and explore changes that may help you become better prepared.
- If you decide to take a lump sum in lieu of monthly pension payments, you may want to consider rolling it over to an IRA. A direct rollover from your employer's plan to your IRA provider (trustee to trustee) will not be subject to immediate taxation and may be the best way to preserve the tax-deferred status of this money. You should consult your tax adviser.
If you do receive a lump-sum payment offer, review it with a trusted financial adviser. Everyone's circumstances are different. What is right for your friend, neighbor, coworker, or relative may not be right for you.
Next steps to consider
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This video explains your two main options when taking a pension payout.