If you're lucky enough to have a pension through your work, some companies offer several options on how to receive your benefit upon retirement. You may be able to take the traditional monthly pension or as a one time lump sum upon retirement. Which option is right for you depends on the offer and your situation. Here are some things to consider as you make your decision:
Monthly Pension Option
You will receive a monthly benefit much like a paycheck. You may be able to choose from several options such as a single life annuity, 100% joint survivor, 50% joint survivor, etc. The one thing they all have in common is that they all guarantee a monthly benefit for at least as long as you’re alive.
Pros of a monthly pension
There is no stock market risk. The monthly amount gets deposited into your bank account even if the stock market crashes. This makes your income more predictable and it will never run out (at least in theory).
Cons of a monthly pension
The extent that your family will benefit from the pension depends heavily on how long the pension beneficiaries live. If a lifetime option is selected (as opposed to a period certain option), and the pension beneficiaries get hit by a bus a week after the benefit starts, that’s all she wrote - the pension plan wins because they barely paid anything out and nothing gets passed on as an inheritance to kids or grandkids. All the money you worked for and earned in that pension goes to somebody else instead.
As things get more expensive for you during retirement (due to inflation), most corporate pensions do not increase your monthly pension to match those rising costs. Some government pensions will increase, but more of them are moving to “simple” pension increases while inflation tends to work in exponential terms. During a 30 year retirement, the dollar may loose as much as 60% of its value. So inflation should be a main consideration in your retirement plan. With the monthly pension, you are putting yourself on a fixed income during a time when expenses are increasing.
Also, if the company or union runs into trouble, they may not be able to make good on their promise to pay your pension. Here is a recent article citing a great example of this threat. Ultimately, the money is promised to you, but it is not guaranteed (nothing in life is, except death and taxes!). The Pension Benefit Guarantee Corp (PBGC) may be able to kick in at least part of a broken pension, but you’re unlikely to see your whole benefit.
Lastly, you will not have any control over your taxation. Whether you need the money or not, it’s coming in (and getting taxed!).
Lump Sum Option
Or you could take the whole thing up front and roll it into an IRA (done correctly, this is not a taxable event). I normally see the lump sum option fluctuate based on the 10 year treasury yield - as yields rise, lump sum amounts sink. Treasury yields are still far below the historical average so lump sum options may still be attractive. In the future, if yields normalize to their historical average, lump sum options will likely not be as attractive.
Lump sum pros and cons are basically the exact opposite of the “guaranteed” monthly pension option we just discussed.
Pros of the lump sum option
Even if the pension beneficiaries get hit by a bus the day benefits start, the lump sum balance can get passed onto whomever is named as a beneficiary on the account. Your family is able to benefit from the work you did and money you earned doing it.
If the company gets into trouble after they pay you the lump sum, it doesn’t matter! You already have the money.
You have much more control over the taxation of those lump sum dollars because it only gets taxed when you decide to withdraw it from the IRA. However, in the year you turn 70 1/2, the IRS will require that you take some out every year because they want to collect taxes from you.
You can invest it based on your situation. By investing a portion in the stock market, you can potentially use the lump sum as a growing source of income for the remainder of your retirement. Companies in the S&P 500 have a strong history of increasing their dividends over time. That means you could position yourself with a rising source of income to match the rising costs of living in retirement.
Cons of the lump sum option
By investing in a portfolio of securities, there is no guarantee on the performance of the investments. Poor performance in the investments could negatively impact your plans in retirement.
So what should you do?
When comparing options, you may want to consider what other financial resources you will have upon retirement, how much you plan on spending at that time, what your goals are regarding leaving an inheritance and what your risk tolerance is for investing.
There are elements beyond our control with either choice - length of life, inflation, investment return, health of the pension, etc. I help clients and prospective clients make informed decisions in the face of these uncertainties. I invite you to contact me if you would like to meet and review your situation and to compare your options.