Many retirees are given the option with their company pensions of taking a fixed monthly payment or accepting a single lump sum payment. Careful consideration should be given to making the proper selection, because once you choose one or the other, your choice is locked in for life.
The monthly payment option typically also comes in an assortment of choices which further add to the complexity of the decision. The retiree can take a payment for his/her life, a payment for both spouse’s lifetimes, a single payment for life with at least ten years of payments, payment for life with fifty percent to the spouse, etc. Often these mix-and-match choices can add up to more than a dozen options. Typically your first prerogative is to protect your spouse. Thus, the generally preferred alternative is to take a reduced payment so that your spouse will have some income if you die early. Often this is advisable, but the real answer depends on all the resources you have available and on your retirement goals.
So, how do you decide which choice is the best choice for you? The only way to know for sure is to know how many years you have left to live. Fortunately, none of us know this for sure, so certain assumptions need to be made. I prefer to build a complete retirement plan for each of the primary alternatives. The planning method I utilize will indicate a projected level of success you will have to receive a steady stream of income or a paycheck for your retirement years, in addition to ending up with a pre-determined amount of net worth at death. A thousand different simulated retirement projections are run to determine what percentage of time you are successful under a multitude of different outcomes given the dynamics of our economy.
Here are some general guidelines for you to consider as you seek to decide in favor of one option over another.
Monthly Payment Option
- Payment is predictable, so one has less worry during negative movements in the market.
- Monthly payment is often higher than would be advisable to draw from a lump sum portfolio. For example, the monthly payment may be 6-8 percent of the foregone lump sum option versus a recommended safe withdrawal rate from a portfolio of 4-5 percent.
- If you have other retirement assets, you may be able to draw on the predictable payments and allow the rest of your retirement portfolio to grow untouched.
- This option tends to work well in sustainable low inflation environments.
- This option is similar to investing in a permanent bond.
- There is no inflation adjustment to the payment. What might appear to be a nice cash flow when you first retire might put you into a fixed income squeeze in the long term. For example, given an average inflation rate of 3%, a $1,000 monthly payment would only buy $473 worth of goods or services after a typical twenty-five year retirement.
- It is normally assumed that the payment is guaranteed and safe, but it is not FDIC insured or government insured. It is only guaranteed by the company making the payment. Some retirees have expressed that they no longer trust their company to be wise stewards of their resources after observing the actions of the corporation over the course of their working years.
Lump Sum Option
- Flexibility: You have the choice of building your own retirement portfolio paycheck for the rest of your life, and if you really need to, you can have access to the remaining principal at any time.
- Flexibility: If you don’t need the monthly cash flow because of other resources, you can suspend the monthly portfolio paycheck and save it for a rainy day.
- The unused portfolio is available to your heirs if you don’t spend the money yourself.
- This option tends to work better in medium to higher inflationary environments as portfolio assets may be flexible enough to adjust with inflation.
- Portfolios are subject to negative market adjustments. The portfolio needs to be well diversified and balanced to deal with market volatility.
- Management of the portfolio increases your administration costs, or this duty needs to be delegated to a professional investment manager.
Your Company’s Position
In the end, the company making the offer is neutral on which option you should choose. If you take the lump sum, they simply make the payment to you and then have no further responsibility. If you choose the monthly payment option, they will use today’s low interest rates and purchase an annuity contact to fulfill their future responsibility. The key question is whether you can on average exceed this rate on your own.
How do you decide?
My core value for retirees is to not take more risk than is necessary to meet your needs and achieve your dreams in retirement. At first glance, I typically lean toward the monthly payment option just because of the appearance of safety. However, if you are projecting a higher inflation rate in the future due to government overspending and additional printing of money, then strong consideration needs to be given toward taking the lump sum and applying strong portfolio management. Risk taking typically pays off over time, but the volatility of the market can be unsettling for short periods of time. Sometimes, what appears to be a lower risk option of taking the monthly payment ends up being the higher risk option, since the payment is no longer flexible and becomes worth less and less every month due to inflation.
Taking the lump sum option and rolling the money into a qualified Individual Retirement Account (IRA) avoids taxation until you take out the money.
The right answer comes from building a retirement plan projection under both options to see which one gives you the greater safety and likelihood of achieving your goals.
Remember, at Dickinson Investment Advisors, we provide planning and investment services that are tailored to our clients’ unique needs and life circumstances, with a goal of achieving wise financial stewardship of your resources in retirement.
Ron Dickinson, CPA, CFP®, MPA-Tax