Should I take a lump sum or monthly pension?
August 27, 2013
Q: I receive $1,670 monthly from a pension, and have been given the option of receiving a lump sum instead. How could I invest that lump sum to get the same amount of income for my monthly expenses?
A: The crucial piece of information here would be how big the lump sum is. But even without getting that specific, it is worth reviewing some of the issues involved in this decision so you'll know what to consider.
A significant problem with taking a lump sum over a guaranteed income stream these days is that it's hard to generate much guaranteed income on your own. According to the FDIC, rates on savings accounts average just 6 basis points, and even five-year CDs average just 74 basis points. The most competitive savings account rates listed on MoneyRates.com are up around 1 percent, while the best CD rates are at around 2 percent for a five-year term.
At 2 percent, you would need slightly more than a million dollars to produce $1,670 in monthly income. Chances are, the lump sum you are being offered is nowhere near that amount, because conceptually your future monthly payments are supposed to be substituted by a combination of the principal of the lump sum plus its potential earning power, and not just the earning power. In other words, you would likely have to draw the principal down over time, which brings up another important issue: longevity risk.
Longevity risk is the financial uncertainty that stems from not knowing how long you will live. If it turns out that you live a long life, you may well get more out of the monthly pension. On the other hand, if you have relatively few years left, then a lump sum might be more rewarding because you would get your money up front. Your current age and health are obvious factors in this decision, but so is the issue of whether the pension has spousal benefits. If a surviving spouse would continue to receive pension benefits, that adds more to the potential future value of continuing to receive monthly payments over a lump sum.
You assume responsibility for a number of uncertainties if you take a lump sum, though one thing you wouldn't have to worry about is the future financial condition of the plan sponsor. If that plan sponsor falls on hard times, it could jeopardize the future funding status of the pension plan. However, if you don't think that will be a problem, you may want to stick with the certainty of those monthly payments, unless the amount being offered via the lump sum is extremely generous.
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