The number of companies that offer pensions is dwindling because longer life expectancies, and the obligation to provide a promised benefit month after month, make them balance sheet busters. As companies remove the shackles of sending monthly checks long after employees have retired, they’ve shifted the burden of saving for retirement to employees through 401(k) plans and other savings accounts.
Yet some employers, particularly those with high union representation, still have pension obligations. If you work for one you may be given the choice of keeping the pension, if you’re eligible, or accepting a lump sum payout at retirement. A change in policy from the U.S. Treasury Department this year, which reversed earlier guidance that prohibited employers from offering a lump sum to those already receiving pension payments, is likely to make the practice of opting out even more common.
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A higher pension means a higher payout, and a lump sum offer of several hundred thousand dollars isn’t that unusual. But according to some experts, it’s often not in your best interest to take the bait. The fact that companies are offering the lump sum option to save money is a good indicator that usually, it’s a better deal for them than it is for employees.
The major advantage of a pension over a lump sum payout is that it’s a regular, monthly check that will come for the period of time that the recipient chooses. Common arrangements include payments over a single life, or over the life expectancies of the recipient and the surviving spouse.
By contrast, a lump sum represents a big unknown because you don’t know beforehand how long it will last. Over the long-term, it may be the better choice if it’s invested and spent down wisely. But often, that’s not the case.
“Often retirees think that if they exchange their pension for a huge chunk of money – sometimes as large as $300,000 or even $400,000 – they can do a better job investing it themselves in the stock market,” observes Karen Friedman Executive Vice-President and Policy Director at the Pension Rights Center (PRC). “But economists warn that rarely, if ever, can people replicate the security of a pension.”
While a lump sum seems like a lot of money it will short-change most retirees
While a lump sum seems like a lot of money it will short-change most retirees, according to Norman Stein, a Drexel law professor and senior advisor to the PRC. Stein says that because of interest rate assumptions, loss of legal protections, and insurance of benefits, retirees will lose a significant part of the value of their pension by taking a lump sum.
Still, there are certain situations where it makes sense to go for the lump sum. Here are some considerations to keep in mind:
Younger and healthier individuals or couples could live several decades beyond retirement, which generally makes the pension a better choice for them. On the other hand, a lump sum could be preferable for an older individual in poor health.
Taken together the combined lifespan of a married couple could be longer than that of a single individual, which lengthens the need for cash flow. This factor tilts things in favor of the pension.
If you’re a confident investor willing to allocate a decent portion of the lump sum in equities for growth and stick to a reasonable withdrawal plan, you or your beneficiaries could be better off down the road. The value of investments can also increase with inflation. By contrast, a pension usually doesn’t adjust for inflation, which erodes purchasing power over a decades-long retirement. Still, if your investment and budgeting skills leave something to be desired you may be better off with a sure thing that the pension represents.
If you already have a sufficient income stream to maintain a desired lifestyle, a lump sum could be a good way to grow your account and enhance a gift-giving or estate plan. This could be the case, for example, if a spouse already has a pension, and you both have generous Social Security checks and a decent-sized nest egg generating regular dividends and interest.
Once the recipient or surviving beneficiary dies, pension payments usually cease. With a lump sum, there’s an opportunity to pass the portion that has not been spent down to heirs.
For some companies, pensions represent their largest liability and many struggle to pay them. While a federal agency called the Pension Benefit Guarantee Corporation (PBGC) has stepped in to pay benefits when companies drop the pension ball, it imposes limits maximum guaranteed benefits. Because so many former employers have had trouble paying their pension obligations the PBGC is also facing financial difficulties of its own, making the seemingly airtight guarantee of a pension a little leakier than some might feel comfortable with.
Bottom line: For many people, the security of a pension is hard to beat. But for those with investment know-how (or a good financial advisor) who already have enough income to achieve a desired lifestyle, a lump sum might be the better choice.
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