If you have an “old school” pension, you will face a tough decision at some point. Do I take the monthly checks or the lump sum payout? Now, many companies or employers don’t offer pensions at all. That makes this a non-issue. Other employers, having pensions, don’t offer lump sum payouts as an option. Again, this makes it easier, at least from a decision-making standpoint. Which one should you take? Should you take a partial lump sum if that’s offered? As more and more companies are offering these options, more people are struggling with this decision. Here locally in St. Louis, companies like Boeing, Anheuser-Busch, and others are seeing their workers faced with this tough and life-lasting decision.
Unfortunately, there is not a definitive answer. There are many factors, both math and non-math, that come into play. An honest discussion and analysis, gives weight to the pros and cons of all the options. In some cases, there can be a stress-inducing number of possibilities for your choice. How do you make that decision? How do you feel good about that decision after you’ve made it? Let’s take a brief look at some of those considerations.
Returns. The math and estimating returns is probably the easiest concept of this topic to understand. Selecting the monthly checks gives you the sense of security. The checks provide a promised “guarantee” to you. The word guarantee should condition you to ask two things: by whom? And, at what cost? In this case, the by whom part is generally covered. It would take an extreme set of circumstances for your monthly check to be in jeopardy. For the second part, know that any guarantee must come with a cost. Why would anyone provide a guarantee if they gave you all the upside? There are countless math examples available by a simple internet search. We can generalize for our purposes here. Over the likely decades of your retirement years, the monthly checks will cost you in the ballpark of 50% of your potential returns. And, that’s okay. You have to decide if that steady check, that is there each month, is worth that price. Pension checks typically have a 3-5% rate built into them. That’s how they come up with the monthly check amount. A diversified portfolio, if managed with proper principles over time, has historically done twice that or better. It does that with uncertainty and market fluctuations, though.
Inflation. As we’ve seen, having that “guarantee” comes with a cost in terms of reduced returns to you over time. The other challenge retirees have is coming to terms with the monthly amount being fixed for life. If you have a pension that adjusts over time to the cost of living, that’s a very rare and positive feature. The overwhelming majority of pensions do not adjust upward. They are fixed for the remainder of your life or the life of your spouse (if that option is chosen). This can lead to a belief, in the first few years, that the payment “isn’t bad” in terms of the annual percentage compared to the lump sum. In some cases, your annual checks can be up to 7 or 8% of the lump sum. Over time, with no inflation adjustment, that check gets smaller and smaller in terms of purchasing power and how much of your expenses it covers. The lump sum can offer that inflation protection. With most people choosing a diversified portfolio of stocks (owning companies) and bonds inside their IRA, inflation is accounted for in the ongoing growth. The companies you own make the products and offer the services that cost more. You don’t need to fear inflation.
THE OTHER “HARD TO MEASURE” FACTORS
Ownership. If you choose the lump sum, you will roll that to a new IRA (Individual Retirement Account) or that lump will join up with an already existing IRA owned by you. If you choose the monthly pension payments, you will receive a monthly check according to the rules of your specific selection. In short, if you select pension checks you do not personally own that asset. It’s essentially managed, on your behalf, by another entity. If you choose the lump, you will own it.
Flexibility. If you select the pension checks, there is virtually no flexibility. Any flexibility there is, is in the initial choice. You’ll have up to a handful of pension options (single life, 100% survivor, 50% survivor, etc.) to choose from. Once you select it, it is an irrevocable decision. You cannot change your mind later. This reality is what often scares people. The fear of regret. On the other hand, handling a large lump sum rollover to an IRA can be scary too. But, it does provide unlimited flexibility. You can leave it alone to grow. You can build it out as your own customized payout plan. You can take similar distributions from the company proposed formula. You could take a year off from distributions if your budget finances are good. You could “double up” on distributions if you have a tough year and need the cash. When you own the money, the choice in terms of flexibility, is perpetually yours.
Risks. THE LUMP SUM. It really depends upon how one defines risk. In the short term, a lump sum will subject your pension money to market fluctuations. Having your principle subject to ups and downs can have a cost to your peace of mind. This option comes with the real risk of you “mismanaging” your funds over time. If you’re prone to panicking in down markets and getting over exuberant in up markets, this can pose a problem. A lump sum can make you, your own worst enemy. This mismanagement could, in a worst case scenario, lead to you outliving your pension money.
THE MONTHLY CHECKS. Again, it really depends upon how one defines risk. The major risk of pension checks is inflation gradually eroding the purchasing power of your checks. There is the risk of having less money over time, which is very real. However, you know that by selecting this option, you are sacrificing on the dollar returns. In very rare cases, your pension amount could be reduced or eliminated. Aside from inflation, the other significant risk is premature death. In the event of your death, your spouse will likely see that check reduced or eliminated (depending on the specific option you choose). In the event of both of your premature deaths, a lesser risk but still possible, your pension essentially vanishes into thin air. It’s gone completely. It does not pass to your heirs and stay in your family. Again, this is due to the fact that you don’t own it in the same way you own a lump sum payout.
Unfortunately, there is no simple “one size fits all” answer. If there was, you could plug all your data into some computerized formula and out would pop the correct strategy. You can largely do that for the math (with some assumptions), but not for those other tough and personal considerations. Perhaps the best question is, can you handle the long-term management of owning the lump sum? Or better yet, have you put in place a time-tested process (both for planning and investing) based on enduring principles? If the answer is yes, then the lump sum should be a great fit to yield better results, a higher likelihood of achieving your goals, and more overall money for you, your family, and potentially your heirs. If the answer is no (after an honest look in the mirror), then having the company retain your pension and living under their formulas could be that “protection from mismanagement” you’re looking for. I bet there are a bunch of ex-lottery winners wishing they took the pension payouts. I bet there are responsible retirees wishing they took the lump sum.