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PENSION OR LUMP SUM? 5 FACTORS TO HELP WITH THE DECISION

PENSION OR LUMP SUM? 5 FACTORS TO HELP WITH THE DECISION

June 29, 2018
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When deciding between a lump sum or a pension payout, there are a multitude of factors that should be considered (you could certainly argue for more than five), most of which involve some level of subjectivity, but all of which could help make the decision. The debate revolves around shades of gray, so if someone presents the answer to you in black and white, ask someone else. I’ll delve into as many of the factors as I can think of, considerations ranging from the entity that controls the pension (public or private), the funding status of the pension, the payout amount and payout options, personal income and gifting wishes, one's desire for control and flexibility, and maybe a couple of bonus points if I’m really on my game.

  1. Since this decision is one fraught with complexity, we’ll try to start in a place that’s pretty simple and work to a place that’s increasingly less straightforward. The first consideration is simply, based on math, which option would you prefer. I will speak in generalities, but know that all pensions are different and you will ultimately need to know more about your specific options than the "average" options. When it comes to pension vs. lump sum option, the choice usually boils down to whether or not you place a greater value on a regular monthly income and the potential for a higher level of income or whether you value having a greater level of control. Pension payouts (as a percentage of the lump sum) can range from five(ish), to numbers sometimes higher than 9 percent per year of the lump sum withdrawal option (for example, if the lump sum was $100,000, the pension might pay $9,000/year). Because of this, if you have 30-40 years of retirement planned ahead, it would be in some cases difficult and in most cases, irresponsible, for an advisor to tell a client to take a lump sum over a pension based solely on the amount of income that that pension can provide. That’s because responsible withdrawal rates from a portfolio usually start in the 3-5% range and may climb very slowly upward from there based on different factors such as age, potential investment returns, etc. High investment returns allow for higher potential payouts from lump sum options, but also add a much higher degree of risk and greater possibility of failure. In summary, if the only thing that matters to you is the level of monthly income you receive on day one, it’s a rarity that a lump sum will compare favorably to the pension option.
  2. So let’s say the pension offers to pay us 9% a year and you can safely withdrawal 3-5% from a portfolio, why choose the lump sum? There are a lot of reasons and this is where the complexity is introduced. First, let’s say the annual income afforded by the pension is $60,000/year and you only need $40,000. By taking the lump sum, you may be able to cover your immediate income needs, as well as retaining control of the money, giving you the ability to take out larger withdrawals for specific needs along the way, and possibly pass some money along to the next generation. Such a decision isn’t wrong, it’s just a way of expressing that you value control and flexibility and goals other than monthly income. If you take a life only (meaning it pays out over the course of one person’s life and once they pass, the income is gone forever) pension option that pays $5,000 in the first month and then you die unexpectedly, there’s nothing left to pass on (this is why pensions typically pay higher distribution rates than what you can safely withdrawal from your portfolio – because some people live shorter than average lives and, in essence, those people subsidize those that live longer than average). As far as payout options, most plans will mandate married couples take joint and survivor options unless one spouse signs off on not doing that – the difference between the single life and joint and survivor payout is a potential planning opportunity, but one that requires its own paper.
  3. What about the source of the pension? Why does that matter and what are the different types of sources? Obviously lots of different entities offer pensions, but for now I’ll just separate governmental entities and private/public businesses. Why does this distinction matter? Well, the biggest reason is that governmental entities are generally backed by the taxing power of the local, state, or federal government that they stem from, meaning that if they’re severely underfunded, there are ways they can use blunt force to make up for their shortfalls. Businesses, on the other hand, don’t have such a tool in their toolbox. There is historical precedent for businesses raising money, but this has logical constraints. Companies can do this until the point that they’re insolvent or the public doesn’t have the faith in them to buy such an offering (effectively rendering them insolvent), at which point they end up in the situation that multiple companies did during the Great Recession – they file for bankruptcy protection. You could say that the same constraint applies, to some degree, to governmental entities, and that’s true, but it’s fair to say that the federal government has a bit more wiggle room than a private company, especially since the US is an autonomous issuer of our own currency (we can print money). Take this entire point how you will, the gist of it is if you are in a pension from a private company that is in dire straits, your pension may not have much of a backstop and even an attractive payout may not be your best choice.
  4. This brings us to the next point, the funding status of your pension. It has been widely reported on a national level how many pensions in the US are now underfunded. To put specific numbers to the issue, Pew Charitable Trusts looked at state pension funding in 2016 and found that they were cumulatively underfunded by $1.4 trillion – that’s TRILLION. This problem exists even with what some would call optimistic return assumptions – the median assumed return being 7.5%. Lowering those by just one percent leads to underfunded liabilities of over $1.7 trillion, yikes. It’s important to note that some states are funded at levels as low as 31% and as high as 99%, so the state you receive your pension from is not insignificant. 1

What about the pensions of private and publicly traded companies? Are they any better? If you look at the top 200 pension plans in the S&P 500, the answer is a definitive ‘NO’. The 200 largest defined benefit plans in the S&P 500 (considering how many assets the plan holds) shows only 14 that are fully funded, meaning 93% of the plans are not. Two well-known companies cited in the Bloomberg article, Intel and Delta Airlines, are both under 50% funded. 2

You can ignore the funding status of your pension at your own peril – it might not be your only consideration, but if you’re choosing to stay in a pension that’s only funded to the 31% level, you’re taking on a great deal of risk and putting an awful lot of faith in the system. Some personal finance articles even state that you should always take the pension option if the payout is high enough and you should do so precisely because that’s what they don’t want to do.3 Sticking it to the proverbial man might feel gratifying, but if you’re going to do it, make sure the man isn’t going to cut your pension payout halfway through retirement. Pay attention to and be keenly aware of the potential impact funding status can have on your future.

  1. For bonus points, consider your own personal discipline as a factor in this discussion. If you’re the type of person that can’t ignore the siren song of $500,000 IRA that’s easily accessible to you and you’d be tempted to withdrawal large sums of money on frequent occasions rather than taking money at a responsible rate, maybe it makes sense to take the pension option to save you from yourself.

All of this is to say that the decision between a pension and lump sum option is rarely simple or easy and because it is often a once in a lifetime choice, you should exhaust all of your effort to make the decision that’s most favorable to you. Often that should involve a financial professional, but if it doesn’t, think about all of the factors above when you make the choice. If your plan is well funded and you value monthly income amounts or you fear what you would do with the lump sum if left to your own devices, the pension option will very frequently be the obvious choice. If, on the other hand, you don’t have a need for the level of income the pension provides, the pension is severely underfunded, you value control and/or have wishes to pass on money to another cause or generation, lump sum options can make sense even considering less generous withdrawal rates.

 

1http://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2018/04/the-state-pension-funding-gap-2016#0-overview

2https://www.bloomberg.com/graphics/2017-corporate-pensions/

3https://clark.com/personal-finance-credit/when-you-should-take-lump-sum-over-pension/

This information is provided for educational purposes only, is believed to be accurate, and is not intended to provide specific financial advice and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or financial services professional.

Income provided by government and private pensions is subject to specific risks.  You are strongly encouraged to discuss your plan and the risks associated with your plan prior to making any financial related decisions.   

The rates, assumptions, etc., used in this article are strictly hypothetical examples and are included for illustrative purposes only.  They should not be deemed as specific representation of any specific past or future results and your actual situation may be materially different.  Past performance in no way implies future results.