Private-sector pensions are a vanishing breed. Defined-benefit pension plans are being replaced by defined-contribution plans such as 401(k)s, mainly because pension plans are costly for employers to fund and maintain. As a result, employers are beginning to offer lump-sum payout options to their retirees to replace the traditional lifetime monthly payments of a pension.
Once a lump sum is paid out, the employer's obligation to the retiree has ended. It is a great deal for the employer — but is it a great deal for you as the retiree? It may or may not be, depending on a few factors specific to your situation.
The Consumer Financial Protection Bureau (CFPB) recently published a guide to help those who are approaching retirement make a decision on how to handle their pension. The guide discusses specific aspects of the decision-making process, along with links to other relevant and helpful resources. Here are a few representative points from the guide.
- Expected Lifespan – If you are in poor health as retirement approaches, you may want to take the lump-sum option on the assumption that lifetime monthly payments will not return the amount you paid in. You may need the money in the short term to deal with medical bills. However, you will generally have an option to transfer your remaining benefits to a beneficiary if you prefer.
- Investment Skills – Taking the lump-sum payout is another way to say, "I can manage my money just as well as the pension company, if not better." Can you really? Have you shown sufficient skill at investing throughout your life? If not, you should strongly consider leaving the management of your retirement funds to the pension fund managers.
- Taxes – Note that lump-sum payouts are considered to be ordinary income in the year it is received, and your employer must withhold 20% to pay the taxes on that payout. Make sure you take that into account if you are going to choose a lump-sum payment because of a pressing need for cash. If you can afford to do so, rolling a lump sum into a different qualified retirement account such as an IRA can defer your tax burden.
- Security – Risk tolerance should be an important part of your calculation. Pension funds are typically relatively conservative in their investments, and you may be able to improve on that through your own investments. Investing a lump sum wisely can extend your benefits beyond what your pension can provide, but you can also lose significant money in a down market no matter how solid your investments are. Pensions, on the other hand, are guaranteed by the Pension Benefit Guaranty Corporation in case of plan failure, ensuring that you will get a significant pension no matter what happens. Traditional pensions also provide some protection from certain creditors seeking your pension payments.
- Inflation – Pension payments are not often indexed for inflation. In times of low inflation, like today, that is not an issue — but over the course of your retirement, inflation is likely to rise up at some point. Factor that into your decision as a potential risk of not taking a lump sum.
In any case, the guide suggests that you review your pension statement to check for errors. Multiple factors go into determining your pension payments, and a mistake in any one of those could cost you over the rest of your lifetime.
There are plenty of other resources along with the CFPB guide to help you decide. Educate yourself on the options through these resources and make some baseline calculations on how well your lump-sum investments would need to do in order to achieve your preferred retirement income.
Do not let an employer talk you into taking a lump-sum payout without doing some due diligence. Let your own research help you decide what is best for you — and do not hesitate to use the services of a professional financial advisor if you need help.
Let the free MoneyTips Retirement Planner help you calculate when you can retire without jeopardizing your lifestyle.