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Lump Sum Distribution vs. Monthly Pension Income

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senior_manQuestion:

When I retire, I will have two options for receiving money from my pension: $10,000 a month for life or a $2 million lump sum distribution. Which is better?

Answer:

First of all, congratulations on earning what sounds like a generous pension. That should set you up well for a comfortable retirement. Naturally though, you want to make the most of your options.

There is a mathematical element to answering the question of whether a lump sum distribution is better than monthly pension income, but there is also more to it than just crunching the numbers. Because of this, the right answer might be different for two different people, even if they were entitled to the same choice of benefits.

Crunching the numbers: lump-sum vs. monthly pension

First the numbers. Simple math tells you that your $10,000 monthly distribution would total the equivalent of the $2 million lump sum option in 200 months, or 16 2/3 years. However, money received in the future is less valuable than money received today. You could use a broker to invest and grow money received immediately, while money received at some future date is likely to have its value eroded by inflation.

For these reasons, future amounts are often discounted to calculate their equivalent present value. For example, using the fairly risk-free 2.70 yield on a 10-year Treasury instrument to discount the option of $10,000 in future monthly pension income suggests it would actually take nearly 265 months (i.e., 22 years and one month) for those future cash flows to have the equivalent value of $2 million received today.

Other considerations for retirement income vs. lump-sum distribution

Based on this calculation, 22 years and one month is the breakeven point for deciding whether the lump-sum distribution is more valuable than the potential monthly pension income. Given the numbers that you have provided, and assuming there is no cost-of-living adjustment to your monthly pension income, the monthly option would be more valuable if you expect to continue to receive it for at least 22 years and one month.

Here are things to consider as you evaluate that possibility:

  1. Your age/life expectancy. Your age and your health should factor heavily into your assessment of whether you are likely to live long enough to receive over 22 years of monthly pension payments.
  2. Survivor benefits. If your plan has provisions for your spouse or children to continue receiving some portion or all of your monthly distribution amounts after you die, it could substantially increase the total value of those future payments.
  3. Your comfort with making investment decisions. Taking the lump sum means you are responsible for deciding how to invest it and how to budget spending from it. If you are not comfortable with that kind of responsibility, you might prefer the monthly income option.
  4. Your confidence in the pension's funding. If you choose the monthly retirement income option, you are counting on the pension being solvent long enough to continue making those payments many years into the future. Before assuming that, do some research into the pension's funding status and the long-term viability of the company. While the Pension Benefit Guaranty Corporation, a U.S. government agency, guarantees pension benefits to some degree, there are limits that could affect the amount of your future distributions if your plan runs into financial difficulty.

Whichever option you choose, remember that retirement can last a long time and that brings some uncertainty into play no matter whether you fund it with a lump sum or monthly pension income. Be sure to avoid common budget mistakes to make the most of whatever resources you have to fund your retirement.

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