While good old fashioned pensions have seemingly gone the way of the dinosaur, they still exist for the lucky ones. The big question you'll have to answer come retirement time is whether you want to take your money in a lump sum or to annuitize the amount, where you receive monthly payments.
The fact that people tend to choose the lump sum, even if economic reasons suggest that they should choose the annuity is called the annuity paradox, so say Philipp Schreiber, teaching and research assistant and Martin Weber, chair of business administration and finance, both at the University of Mannheim in Germany. In their recent online survey, they found that people behave time inconsistent. By that they mean older people have a stronger tendency to choose the lump sum than younger people when they are asked to predict today what to choose when they retire.
For sure, deciding how to take your pension money is a big deal. “One of the largest financial decisions, if you are lucky enough to be retiring from a firm that offers a pension plan, is whether or not you should take a lump sum distribution from the pension plan, or take payments over time,” says Jennifer Williams, a certified financial planner with SunTrust Investment Services.
Here's help with how to make the decision.
Talk to human resources
Ask human resources to explain the various pay-out options which include lump sum, payments for your lifetime, payments for both you and your spouse's lifetime and any other potential payment variation, says Williams.
A financial planning rule of thumb is that individuals can take a 5% distribution from their investment accounts to balance the need for income, keep pace with inflation and avoid running out of money, says Williams. This figure will be helpful in determining your options. Multiply the lump sum amount you are offered by 5% and compare it to the monthly payment you are being offered to see how much higher or lower your payment stream will be, she advises.
What you should think about
Get real about your ability to manage money. If you have a tough time saving money, you may want to protect your retirement and opt for the monthly payments, rather than a lump sum, says Williams.
If you have health issues that will decrease your life expectancy, it may be better for you to take the lump sum, as monthly payments do not transfer to your heirs.
As with most, if not all, financial decisions, the answer usually starts with, “It depends,” says Kevin Lynch, an assistant professor of insurance at The American College. “How to take your annuity payments also depends on the following, are you married or single? Are you in good health, or is your health compromised? Do you have other sources of retirement income? What is your family health history, as it pertains to longevity? There are at least another dozen questions you could ask. The bottom line is that your decision should be based on your unique situation,” says Lynch.
You also want to find out if the annuity offers a lifetime income benefit rider. “These riders offer more flexibility with your lifetime payments than your traditional annuitization payouts. You can often turn on an income stream with these riders and still have the annuity's contract value to dip into if needed or pass on to heirs,” says Ron Grensteiner, president of American Equity Investment Life Insurance.
Don't forget Uncle Sam. If you decide to take a lump sum withdrawal, all of the funds will be subject to taxes at that time. Annuities offer the benefit of tax deferral until the funds are withdrawn.
If you go for the lump sum
There are key considerations. How will you invest the proceeds from a lump sum distribution of your pension payment? “In light of the fact that we are in record low interest rates, it simply may not be possible to take a lump sum distribution, invest in CDs and earn a return that keeps pace with inflation and pays you a livable monthly amount,” says Williams.
Think too, about your risk appetite. “You will most likely be required to consider higher risk investments, such as stocks or corporate bonds to generate a return on your lump sum payment,” she cautions.
Another helpful rule of them when considering adding equity risk to your portfolio, is to subtract your age from 100. This should approximate the amount of equities you may want to consider. For example, if you are retiring at 65, then 100-65 = 35% of your lump sum retirement balance should be invested in stocks or equities, says Williams.
If you choose monthly payments
Quite simply, if you have a low risk tolerance, you may be better off taking a monthly payment from your employer, says Williams.
Know however, if you take monthly payments, you are essentially pushing the risk back to your employer. It will be their responsibility to manage your money in a prudent fashion so that you receive payments for the rest of your life. “If you have significant questions about your old employer's ability to make good on this promise t pay, you may want to consider the lump sum payment,” says Williams.
Accounting principles require companies to calculate their unfunded pension liability. The larger this number, the more likely your company could have issues paying your monthly pension payments over time.
Be sure you're clear on fees, both explicit and “hidden” imbedded in the investment solutions you use, as the more you pay in fees and commissions, the less you have to spend in monthly payments.
Deciding what to do with your pension payout is such a big choice that you likely shouldn't make it on your own. Do get the help of a trusted financial advisor.