Retirement planning was not always as complicated as it is today. There was a time when 30 years of service was rewarded with a golden watch and a lifetime pension. Today fewer and fewer employers are offering pensions and the ones who do are looking for ways to reduce the long-term obligations associated with pension plans. One of the strategies that employers are using to reduce these long-term obligations is lump sum buyouts.
A lump sum buyout is an offer from your employer of a one-time lump sum payment in lieu of monthly payments for life (and your spouse’s life if you select a spousal benefit option). Here are factors to consider when determining if a lump sum payout is right for you:
How Life Expectancy Factors Into a Pension Buyout Decision
Life expectancy is extremely important when determining if a lump sum makes sense for you. The reason life expectancy is so important is because the longer you live, the more monthly payments you will receive. For example, let’s say you are offered the choice of a guaranteed monthly payment of $3,000 or a one-time lump sum of $500,000. If you pass away in two years you will have received only 24 monthly payments or $72,000. Monthly payments did not work out so well. On the other hand, if you live 30 years you will have received $1,080,000—significantly more than the lump sum offered.
Obviously, none of us know how long we are going to live but you can make an educated guess. Consider your personal health and the longevity of your family members. If you are in good health and have had several family members live into their late 80s or 90s, monthly benefits start to look more attractive. If, on the other hand, you are in poor health and/or have had few family members live into their 80s or 90s, the lump sum option may be better. If you are considering a spousal option for your pension (i.e. your spouse gets a portion of or the full monthly income after you pass away) it is very important to consider these factors for your spouse also. (For related reading, see: Can I leave my pension to my spouse when I pass away?)
Keep Your Risk Tolerance in Mind
Risk tolerance is a person’s willingness to accept risk for the possibility of higher investment returns. A person who is risk averse is more likely to accept a lower rate of return for greater certainty of future outcomes. In other words, a risk averse person prefers safe and stable investments even if it means slow growth. A risk seeker, on the other hand, is somebody who is willing to accept uncertain returns (volatility) for the hopes of higher investment returns.
Most people are not 100% risk averse or 100% risk seeking. Most are somewhere in between. The more risk averse you are, the more likely it is that monthly income rather than the lump sum makes sense for you. Conversely, the more of a risk seeker you are, the more likely it is that a lump sum makes sense for you. The reason your risk tolerance is important when determining if a lump sum is right for you is twofold. First, a risk averse person likes certainty and a monthly income from a pension plan covered by the pension benefit guarantee corporation (PBGC) is predictable and guaranteed (subject to the claims-paying ability of the pension plan and the PBGC; see “other considerations” below for more info). Second, the more risk a person is willing to take the higher the rate of return they have the potential to receive over the long run. Of course, a high rate of return means more growth on the lump sum.
Decide Whether You Need Income Now or Later
If you are in need of income right now, monthly payments may make sense for you. On the other hand, if you are not in need of income for several years, the lump sum may make sense for you. A big reason for this is the more time you have to let your money grow before you need to access it, the more risk you can take. As we discussed above, higher risk equals potentially higher returns. (For related reading, see: Lump Sum Versus Regular Pension Payments.)
Questions to Ask Yourself Before Taking a Lump Sum Payment
If you are still considering taking out a lump sum payout, ask yourself these three questions:
- Is your pension fully funded? If your pension plan is distressed or underfunded, the security and dependability of your pension payments could be called into question. You have the right to request information about your pension plan funding from the plan administrator.
- Is your pension insured by PBGC? Some pension plans offered by small personal service employers, church groups, and federal, state, and local governments are not insured. Additionally, many multi-employer plans, created through an agreement between two or more employers and a union (e.g. plumber/electrician union pension plans), have minimal protection through the PBGC. This can become increasingly important if your pension plan is underfunded or distressed. (For related reading, see: Is Your Defined Benefit Pension Plan Safe?)
- Are your pension benefits more than what PBGC covers? PBGC only guarantees a certain amount of benefits. The monthly benefits you are entitled to could be more than what PBGC insures. This also can become increasingly important if your pension plan is underfunded or distressed.
It is very important to take the time to educate yourself on whether or not a lump sum payout is right for you, and you have already taken a big step toward making an informed decision.
The commentary in this article reflects the personal opinions, viewpoints and analyses of Brandon Carter, and should not be regarded as a description of advisory services provided by Financial Strategies Group, INC or performance returns of any Financial Strategies Group, INC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this article constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Financial Strategies Group, INC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.