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Lump
Sum Versus Regular Pension Payments
By George D. Lambert
So
you're on the verge of retirement and you're faced with a difficult
choice regarding your company-sponsored retirement plan: should
you accept the traditional, lifetime monthly payments or take a
lump sum distribution? Understandably, you might be tempted to go
with the lump sum. After all, it may be the largest single disbursement
of money you'll ever receive. Plus, you may like the idea of having
more control over your investments. Employees about to retire face
this dilemma all the time. Before you make an irrevocable decision
about your future, take the time to understand what it might mean
to you and your family.
Why
Employers Offer the Choice
First, you should ask yourself why your company would even want
to cash you out of your pension plan. Employers have various reasons
for offering the lump sum payment. Your employer may use it as an
incentive for older, higher-cost workers to retire early. Or it
may make the offer because eliminating pension payments generates
accounting gains that boost corporate income. Furthermore, if you
take the lump sum, your employer will not have to pay the administrative
expenses and insurance on your money.
Understanding
the Guarantees
Like many retirees, you may find it comforting to know that you
can get a check every month for the rest of your life. But suppose
your employer is in financial trouble - what assurance do you have
that the check will always be there?
The
Pension Benefit Guaranty Corporation (PBGC) is the government entity
that collects insurance premiums from employers sponsoring insured
pension plans. The PBGC only covers defined-benefit plans (stated
payments) and does not cover defined-contribution plans. It earns
money from investments and receives funds from the pension plans
it takes over. The maximum pension benefit guaranteed by PBGC is
set by law and adjusted yearly. For plans ending in 2005, workers
who retire at age 65 are assured that they can receive up to $3,801.14
a month ($45,613.68 a year). The guarantee is lower for those who
retire early or when the plan involves a benefit for a survivor.
And the guarantee is increased for those who retire after age 65.
Therefore, as long as your pension is less than the figures above,
you can be reasonably sure your income will continue if the company
goes bankrupt.
However,
the burden for the PBGC is growing every year. According to a 2005
press release by the PBGC, underfunded plans in 2004 were short
by $354 billion. Compare that to 2003, when that number was $279
billion. In fact, the Center on Federal Financial Institutions has
suggested that the PBGC could run out of money in 15 years.
Why
You Should Take the Lump Sum
According to the U.S. Department of Labor's Bureau of Labor Statistics,
the value of the Consumer Price Index (CPI) has increased an average
of 3% per year over the past 20 years. Yet the cost of health care
has gone up 5.5% during the same period. Does your pension include
cost-of-living increases? What are the increases based on, and will
they reflect the actual amount you'll need to meet your expenses
down the road?
For
example, something that costs $1,000 today will cost $1,344 in 10
years, assuming 3% inflation. But what if your $1,000 in prescription
drugs goes up 5.5%? You'll need $1,708 to pay the same bill in 10
years, and your pension might not have kept up. The pension fund
manager's primary concern is making enough money to send you the
required check each month. In many cases, the pension fund payments
are not indexed to inflation, meaning they will not rise with inflation.
But if you handled the portfolio, you could rebalance the assets
based on inflationary trends and possibly have a better chance of
boosting your income as the years go by.
Do
you want to leave something to loved ones upon your death? Once
you and your spouse die, the pension payments will stop. On the
other hand, with a lump sum distribution, you could name a beneficiary
to receive money after you and your spouse are gone.
Income
from pensions is taxable. However, if you rollover that lump sum
into your IRA, you'll have much more control over when you remove
the funds and pay the income tax. This could be a big benefit when
you start receiving Social Security checks and want to keep that
income from becoming taxable.
Why
You Should Take the Pension
What about your spouse? If you opt for the pension, you can make
sure that he or she will receive a steady income if something happens
to you. But if you take the lump sum, will there be enough money
to provide for your survivor? And will he or she be able to manage
the funds as well as you?
You
also need to think about health insurance. In some cases, company-sponsored
coverage stops if an employee takes the lump sum payout. If this
is the case with your employer, you'll need to include the extra
cost of health insurance in your calculations.
How To Evaluate the Offer
Many employers don't provide side-by-side comparisons of the lump
sum and pension payments options and fall short of giving the information
you need to make an informed decision. Therefore, it's your responsibility
to find out what the numbers mean. Here are some key questions you'll
want to ask:
Is
the value of the lump sum equal to the monthly pension payments
over your estimated life expectancy?
Did your employer remove any early-retirement subsidies in calculating
the lump sum offer? Typically, these subsidies are added to the
value of pension benefits as incentives to entice workers to retire
early, and they could be worth tens of thousands of dollars. If
that amount is stripped out of the lump sum payment, you could be
missing out on a lot of money.
Could you get a better return than the pension fund managers earn?
Calculate how much you would need to earn using your lump sum payment
to equal the benefits of the pension payments. For example, suppose
you were offered $400,000 in lieu of a $2,500 per month pension.
The breakeven point if you earned 0% on the lump sum would be 13
years ($400,000 / $2,500 = 160 payments / 12 = 13.3 years). But
if you could earn 5% each year on your lump sum of $400,000, the
money would last 22 years, assuming you spent $30,000 ($2,500 x
12) annually. But would this be long enough?
According to the National Center for Health Statistics, a 65-year-old
person is expected to live another 19 years, to the age of 84. However,
this is an average. Half of the 65-year-olds will live longer and
half will not. Therefore, a 65-year-old retiree who is basing his
or her retirement plan and spending habits on living to 84 is flipping
a coin. Furthermore, when you consider that there are more than
70,000 U.S. centenarians who represent the fastest-growing segment
of our population, there is reason for you to think of your retirement
in terms of decades, not years. (To learn more about planning for
your retirement, see Determining Your Post-Work Income.)
Conclusion
Putting the numbers aside, when you make your choice between the
lump sum and the monthly pension payments, it should come down to
this crucial question: How confident are you that you'll make the
right decisions to convert that lump sum into a stream of income
that will last the rest of your life? Moreover, do you have the
self-discipline to manage this money, or will you end up using it
to buy a new car, go on vacations or pay down debts? Are you willing
to give up the security of regular pension payments for yourself
and your spouse in exchange for the greater financial control of
the lump sum payment?
Ask
questions, do your research and crunch the numbers - only then will
you have the satisfaction of knowing you've made the right decision.
By
George D. Lambert
