Lester, a 51-year-old from Pittsburgh, has no debt aside from his mortgage. The company he works for recently sent a letter to employees offering them a lump-sum payment when they leave in return for ending their participation in the company’s pension plan.
He can choose a one-time payout of $71,000, or he can opt to take a future stream of income and receive $455 per month for life starting at age 65. With only 30 days to decide, he finds the decision confusing and overwhelming.
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Some companies — looking to reduce their pension obligations and the costs of plan administration — may offer employees the option of a one-time payout instead of a life-long stream of pension benefits.
This is the situation Lester now finds himself in. He’s wondering if he should take the $71,000 lump sum or a guaranteed $455 per month in retirement?
Lump-sum payment or lifelong income?
Crunching the numbers will involve looking at different scenarios for investment returns and inflation. A financial advisor will have access to financial planning programs that can generate scenarios under different economic conditions and help you decide which option might make the most financial sense for your situation.
For instance, the stream of pension payments could be eroded by inflation over time, while — given suitable investment returns — it may be possible to increase withdrawals from the lump-sum amount over time to account for inflation.
His decision may also depend on his other resources in retirement. If he’s worried he won’t have enough savings for retirement, then he may benefit from a lifelong guaranteed income stream.
If Lester takes the lump sum, he’ll need to have the investment know-how and discipline to make the most of that one-time payout.
With a monthly income of $455, it would take about 13 years to rack up $71,000. If Lester invested the lump sum in an S&P 500 index fund — the index has had an average annual return of around 10% over the last 20 years — at a 10% return rate he could earn $245,000 in the same time frame.
But he must be warned: investing the money means it’s subject to market risks, and past returns don’t guarantee future earnings. Meanwhile, those monthly payments would be a sure thing.
Read more: Want an extra $1,300,000 when you retire? Dave Ramsey says this 7-step plan ‘works every single time’ to kill debt, get rich in America — and that ‘anyone’ can do it
Non-financial considerations
Lester’s decision may largely depend on his risk tolerance. If he’s comfortable taking on risk, he may be able to earn a decent return by investing his lump-sum payment. If he’s risk-averse, he may be more comfortable with guaranteed life-long payments.
Risk tolerance isn’t the only consideration. If Lester is in poor health and doesn’t believe he’ll live another 30 to 40 years, he may want to take a one-time payout because he’ll get more value out of it than a short period of payments.
However, if he doesn’t roll the one-time payout directly into an IRA or have it transferred from trustee to trustee, then the money will be treated as ordinary income for tax purposes and 20% tax will be withheld at the time of the distribution.
Also, if Lester withdraws the money from the IRA before he’s 59.5 years old, the money will be treated as ordinary income and may be subject to a 10% additional tax.
Another consideration is how disciplined Lester is with his money. One third (34%) of retirees who took a lump sum from their defined contribution (DC) plan at retirement depleted it within five years, according to MetLife’s 2022 Paycheck or Pot of Gold Study. On average, two out of five (41%) of those who still had assets past five years said they were worried their money would run out.
On the other hand, 96% of those who chose the lifetime payment stream said they were happy they chose to do so and “nearly all annuity-only retirees (97%) use their DC plan money for some type of ongoing expense, such as day-to-day living expenses or housing expenses,” according to the MetLife study.
Regardless of study results, it’s a potentially life-altering decision, one that is personal and requires weighing financial and non-financial considerations.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
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