Deciding whether to keep a pension or take the lump sum option is usually one of the biggest financial decisions someone makes in their life. Since this usually represents a significant part of their wealth, the stakes are huge! Nobody wants to look back 5 or 10 years down the road and kick themselves for their choice. Or even worse, make a poor decision and have finances prevent them from living their best life in retirement. My hope is this guide will give people information to help them avoid common missteps with this process and feel more confident in their decision.
Special 2022 Lump Sum Opportunity!
Rising Interest rates have created a unique opportunity for many pension plan participants this year. If the pension plan is still using the 2021 interest rates to calculate the lump sum, then it is likely that the lump sum payment will decrease by 10%+ as soon as the company updates its rates to 2022. For example, if a participant has a $1,000,000 lump sum option, it could be reduced to $900,000 next year, a loss of $100,000! Additionally, rising interest rates have increased the amount of income investors can receive from non-pension benefits. The twin factors of getting to benefit from last year’s lower interest rates and this year’s higher interest rates can be worth tens of thousands to hundreds of thousands of dollars. While the unique circumstances of this year may increase the relative value of taking a lump sum in 2022, this is just one factor in the decision, and shouldn’t be the only factor considered.
It’s an either-or decision, right?
When first looking at the decision between taking a lump-sum payout or keeping the pension, there are only two choices to make; either keep the pension, or take a lump sum of cash. However, this naturally brings up the next question, “If the lump sum option is selected, how should the cash be invested?” Unfortunately, there are an unlimited amount of possibilities with how the cash could be used. It can feel overwhelming to try and sort through all the different investment options you can use with the lump-sum. I find it helpful to narrow the options into four broad categories.
The 4 investment categories that can be purchased using the lump-sum funds:
- Insurance products. This is primarily annuities. The two primary advantages of annuities are that the income can be guaranteed, and they can offer protection against running out of money, the same two advantages of a pension. One type of annuity that is most similar to a pension is a single premium immediate annuity.
- Steady income investments. This primarily includes high-quality bonds. The income from these investments is highly predictable, and therefore many retirees feel comfortable relying on it for retirement income. Growth investments. This is general investing in companies, whether it be public stocks, real estate, private equity, etc. Retirees feel comfortable relying on the future growth from these investments to fund retirement.
- Growth investments. This is general investing in companies, whether it be public stocks, real estate, private equity, etc. Retirees feel comfortable relying on the future growth from these investments to fund retirement.
- A combination of #1, #2, and #3. Most retirees want a balance in their investments. They want some safe income that they can rely on, but they also want the potential for future growth and the higher anticipated spending that brings.
One step that is always helpful in the lump sum decision is comparing the pension income versus income that can be produced by annuities using the lump sum amount. Single premium immediate annuities that require a lump-sum in return for lifetime income are very similar to pensions. Both allow you to have the peace of mind that you won’t outlive your money. With rising interest rates, annuities may offer rates that are competitive or even exceed pensions! There are many online annuity shopping sites that allow for generalized quotes within minutes. This gives participants a critical piece of information: is their pension paying above market rates? Pensions that pay above market rates for lifetime income make them more attractive than taking a lump sum.
Are annuities a riskier source of income than a pension?
Annuities are generally riskier because company pensions come with more protection. Company pensions usually have three layers of protection:
- Pensions are funded by assets. Private company pensions essentially have their own investment fund that holds millions or dollars of dollars of investments whose sole purpose is to fund the pension.
- Pension is backed by the corporation. Even if there aren’t enough assets to pay benefits, the private company is required to pay for benefits from its profits.
- The Pension Benefit Guaranty Corporation (PBGC). The final layer of protection is even if there aren’t enough assets to pay for benefits, and the company goes bankrupt/ doesn’t have the profits to pay for pension benefits, if it is a member of the PBGC, the PBGC will step in and pay benefits. The PBGC can be thought of as an insurer for the pension. However, the PBGC only guarantees a certain amount of pension income.
Annuities also have three layers of protection.
- Annuities are funded by assets. The insurance company sets aside assets to pay for the annuity (which comes from the money people give to the insurance company).
- Annuities are backed by the insurance company. If there aren’t enough assets to pay benefits, the insurance company must use its profits to pay for the annuity.
- State Insurance Guaranty Associations. The final layer of protection comes in if assets are insufficient to provide the annuity income, and the insurance company becomes bankrupt. If the insurance company is a member of a state insurance guarantee corporation, then the state guarantee corporation will pay out a limited amount of benefits: usually around $250,000 total, although it varies widely by state.
On average, corporate pensions usually are safer than annuities, although it depends on the specifics of the situation. Retirees can reduce their risk the most through annuities by splitting their annuity purchases among different highly rated insurance companies. No matter your source of income there is always some risk.
Steady income investments – high-quality bonds
High-quality bonds offer another avenue for retirement income. Income from the bonds can be calculated ahead of time, and assuming the bonds don’t default, then the retiree can lock in how much their income is for decades in the future. Additionally, retirees can protect against inflation-risk with TIPS bonds. The primary issue with this is even with rising interest rates, interest rates are still too low for many retirees to live off just the interest income, and thus they will need to spend some amount of the bond principal each year. This generally leads to a reduction in interest income each year, and a greater proportion of spending will come from bond principal. This can cause retirees to run out of money later in retirement, as they spend down their bonds to maintain their income each year.
Most growth investments can be categorized as investing in companies, whether it be public stocks, real estate, private equity, etc. There is disagreement among investors about where stocks in mature industries that have large dividends belong. Generally, these stocks aren’t expected to grow much, but instead return most of their profits to shareholders. Retirees can then treat this income as safe income that they can rely on each year. Unfortunately, often times these companies have to cut their dividends, and the dividend payments are not nearly as secure as bond interest payments. Therefore, I still include these companies as growth investments, as you are relying on future profit in the company to fund dividend payments. I believe it’s important for retirees to have a balance of mature companies that pay out most of their profits, as well as companies that are growing quickly that will become the mature companies of the future.
Regardless of which investments you choose one of the key pieces of information needed for this decision is the required rate of return. The required rate of return is the return that the investments purchased with the lump sum funds need to produce to equal the return generated from keeping the pension as lifetime income. This is commonly calculated by using an internal rate of return formula. I will spare everyone the math details. The required rate of return requires an assumption of how long the pensioner(s) will live, and I always recommend run the numbers for each age at least up to the younger pensioner’s age 95 (if choosing a joint pension option).
Let’s use an example to make sense of this. Jane is 65 and can either take a $1,000,000 lump sum or receive $5,000 per month starting now ($60,000/year). If Jane takes the lifetime income from the pension and lives until age 95, that is the equivalent of the $1,000,000 lump sum producing about a 4.25% return each year. This 4.25% return figure is critical because it gives Jane a comparable return figure to measure against her expected return of investing her lump sum. If Jane thinks she can invest her lump sum and earn a higher rate of return than about 4.25%, then it may make sense for her to choose the lump sum option. Alternatively, if Jane figures she can’t do better than it, then it may be wise for her to keep the pension.
Sequence of returns risk
Unfortunately, it is more complicated than this because pensions produce steady returns due to paying the same amount of income each year. Growth investments don’t produce steady returns each year but have returns that fluctuate over time. This matters because even if growth investments produce higher rates of return over a longer period of time, the order in which returns are received can have dramatic effects on spending ability. This is known as sequence of return risk. Because portfolios are typically at their largest at the beginning of retirement, the returns matter more, because there are more dollars at risk. As an example, if you get a 20% return on $1,000,000 that is $200,000 in growth, but a 20% return on $100,000 is only $20,000 in growth. If growth investments produce poor returns and retirees don’t decrease their spending, then the portfolio size may drop enough that when the large returns do appear later in retirement from growth investments, the smaller size of the portfolio dampens the positive effect of higher returns. Sequence of return risks is one of the primary reasons that retirees don’t invest entirely into growth assets.
Combing steady income and growth investments
The fourth option is a combination of #1, #2, & #3. One of the biggest benefits of taking the lump sum option is the flexibility. Getting a big pile of cash creates options. Most people seem to want a bit of both, they don’t want to keep all their money as lifetime income in the form of a pension or annuity, or place everything into bonds and have the value of their bonds eroded by inflation, but they certainly don’t want to take the risk of exposing all their money in the investment markets. This option can combine the best of all worlds by securing a portion of retiree’s spending, while still allowing increased spending based on investment growth. This is where seeing how this decision fits into the broader context of a retirement income plan can help with the decision making. Seeing how the different options coordinate with the remainder of someone’s financial situation can be very beneficial. Coordinating financial resources to deal with income gaps between when pensions and Social Security benefits begin is critical.
That’s an overview of the investment aspects of choosing between a lump sum and a lifetime pension but there are more factors to consider! Here’s a list of the most common significant factors that should influence the decision between taking a pension or lump sum payment.
Health is one of the largest factors in this decision. The value of a pension is based on an estimate on how long people will live. If a pension plan participant knows they have a terminal illness where their life expectancy is less than 5 years, taking the lump sum is almost always the better choice. On the other hand, if a participant knew that they were going to live to age 100, the return on a pension generally gives a reasonable return. The issue is that many people facing the decision have decent health and have no reason to believe they won’t have a long, happy retirement. This is where the risk of the decision comes in, participants don’t know how long they are going to live (or their spouse)! And they don’t know how the investment markets will perform if they choose a lump sum and purchase investments. Having bad health can simply the decision, but moderate to excellent health alone does not simplify the decision.
The Retirement Journey
Humans are not robots, and we have emotions. The financial aspects of the decision have been thoroughly addressed, but one of the most significant factors in this decision is the emotional aspect. How comfortable would it be to rely on investment markets to fund future living expenses? Many people are just fine with this, and others recoil at the thought of taking that risk. Retirees would be wise to not only think through the financial aspect of the decision, but the emotional impact as well. If volatile investment markets will make the retirement journey less enjoyable, and cause more stress and anxiety, that is another factor to consider.
Pension Lump Sum Checklist
There are many variables that can influence this decision, but one of the most effective methods for making a better decision is simply reviewing the factors below and determining how they impact your particular situation. Pilots won’t fly before they complete their pre-flight checklist, and surgeons save lives by using their checklist, so pensioners should consult their checklist before making a decision as well. Please note this not an exhaustive list, and there may be other significant factors that impact your unique situation.
Pension lump sum decision factor checklist
- Are you able to still take a lump sum option based on 2021 interest rates?
- Are you single or married?
- How is your / your spouse’s health?
- Have you considered the emotional benefits/negatives of each option?
- How important is leaving money to beneficiaries?
- How would you invest the lump sum money?
- Does the pension provide more lifetime income than is available by the insurance markets?
- What risks are you willing to accept with this decision, and which risks are you looking to avoid/mitigate with this decision?
- What is the required rate of return that investments purchased with the lump-sum funds will need to produce to match the estimated return of the pension?
- Have you considered sequence of return risk?
- How does the decision impact your retirement income plan?
- Have you considered how you will align Social Security with this decision?
- Have you considered how to bridge the income gap between when your pension and Social Security benefits begin?
- How does the pension decision fit in with your other assets?
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