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Retirement could be one of the biggest decisions of your life, and if you’re faced with having to choose between taking a pension versus taking the money in a lump sum, it can make this situation more difficult.
In today’s blog, we’re going to dive into the specifics around both options and some of the concepts around why it might make sense to choose one way or another.
To start, let’s illustrate this scenario by using the story of two hypothetical clients, who for today we’ll call John and Mary.
After decades of steady work and saving, John and Mary came to a critical point in their journey.
Deciding whether to take John’s pension or opt for a lump sum distribution.
In their case, making this decision brought them anxiety as they wondered about variables such potential short falls on income at some point or if they would be unable to pass assets to their children.
In John’s case, he’s always valued structure and dependability, and the idea of a pension appealed to his need for security.
Often times, pension plans outline steady, predictable monthly payments for a certain period of time where one might not have any concerns as they could be sheltered from the potential volatility of the markets.
For John, the fear of outliving their money had kept him awake through periods in his career, and he sees the pension as a safety net that can protect them from the unknown.
And some research tends to support John’s concerns.
According to a study by the Consumer Financial Protection Bureau, 73% of retirees who receive a traditional pension are able to maintain their spending levels after five years in retirement.
In contrast, only about 56% of those who chose to take a lump sum managed to do the same.
And this statistic underscores the spending stability that pensions can provide, which is exactly what John is looking for.
Mary, however, had a different perspective on things.
With her background as a small business owner, she’s gone through life having to make decisions on the fly and managing risk.
She values flexibility and control, and the lump sum option catches her attention.
The prospect of having a large pool of money available, rather than being tied to a fixed monthly payment, fits her desire for freedom in retirement.
She also brought up the thought of their children and which option could potentially leave a legacy for them.
If they choose the lump sum, one of their options could be to roll the money into an IRA.
Mary’s hope was that they would then potentially be able to grow the money over time and leave some of the asset behind to the kids when they’re gone.
Naturally, this difference in John and Mary’s priorities could create tension.
John being drawn to a sense of stability and predictability while Mary craved the potential for flexibility and the potential to grow their assets for the next generation.
It’s important to note as with many choices, both options come with trade-offs.
John recognizes that while the pension offers security, it may limit their ability to leave a substantial inheritance.
And Mary acknowledges that while the lump sum gives them more control, it also requires careful management and could potentially expose them to market risk.
This brings the point that understanding the trade-offs between a pension and a lump sum can be critical.
And while each path has its strengths and weaknesses, it can be helpful to really understand what matters most to you.
Here are some of the considerations we take into account when working through this process.
Number one, something that we’ve felt in different ways throughout life depending on which generation you are a part of is, inflation.
Some pensions include Cost of Living Adjustments which could increase payments to help offset the impact of rising costs over time.
This is similar to how Social Security benefits tend to get adjusted annually.
For retirees who have access to this feature, it means their income could keep up with expenses like groceries, medical care, and utilities.
However, it’s important to remember that there are also plans that don’t offer this protection, so before making the decision on which option to take, this could be an important consideration.
Another factor to consider is that in some cases pensions don’t typically offer too much flexibility.
Once you start receiving payments, you might not be able to access a lump sum for emergencies or unique opportunities.
If an unexpected expense arises or you want to make a large purchase, you may not have the means to do so without taking on debt or selling other assets.
In addition to this, when talking about planning, we often discuss the thought of leaving a legacy.
Generally speaking, we commonly see situations where a pension will provide payments for the recipient’s life, sometimes extending to a spouse if survivor benefits are selected.
But after both recipients pass away, the income stream could end which could in some cases result in a smaller legacy left behind for the next generation when the time comes.
On the other hand, to put some of the potential advantages of a pension into perspective, you could find yourself insulated from the ups and downs of the stock market.
The structure of a pension could also simplify financial management in some cases.
Not having to review your investments, make allocation decisions, or even find yourself glued to your investment app might bring peace to one’s retirement.
And while some of the appealing characteristics of a pension could seem like a no brainer, the opposite end of the spectrum has it’s caveats to consider as well.
Taking a lump sum and having the ability to manage it yourself or with a team of professionals could fit more naturally in certain instances.
Instead of being locked into a fixed monthly payment, you might have more flexibility where you can decide how and when to use the funds, which to some might be a more attractive option.
Flexibility, whether it be in the form of investment management, tax planning, or even having access to additional funds if you want to splurge on a large trip are just some of the qualities that could come with a lump sum decision.
Beyond spending, the lump sum could open doors to potential for growth through an investment portfolio.
In Mary’s case, she sees this option as an opportunity to tailor investments to her goals and risk tolerance, aiming for growth that could outpace inflation or boost their retirement lifestyle.
When having this discussion, it’s also important to consider that there could be risks that come with the perceived freedom of the lump sum rollover.
First and foremost, if you elect not to distribute the lump sum into any other account aside from a pre-tax account, you could find yourself with tax ramifications you may not have thought of.
In addition, things like sequence of return risk, market risk, and even the timing of your withdrawals could all potentially produce less than desirable outcomes.
Despite the challenges, some folks are willing to accept the responsibility that comes with this option, knowing it could require ongoing attention and planning.
The feeling of empowerment that could come from making your own decisions and the potential to shape both your retirement and your children’s future might be of the utmost importance to you.
So, how do you weigh these risks with potential rewards?
One of the concepts we see commonly used is the 6% Rule.
If the annual pension payout divided by the lump sum offered is greater than 6%, the pension could be the better deal.
If it’s under 6%, the lump sum might have the edge.
And while this rule doesn’t provide a final answer, it could be a place to start.
It’s also important to recognize the limits of this simple math.
The 6% rule doesn’t account for several critical factors that could end up impacting your outcome.
For example, it ignores inflation. If your pension doesn’t include a cost-of-living adjustment in theory, its purchasing power could decrease over time.
What feels like enough income today might not stretch as far in 15 or 20 years.
On the other hand, the rule doesn’t consider the potential investment returns you might earn if you take the lump sum and invest it.
Historically the S&P 500 has had average returns higher than 6% annually over the long term, but to reiterate, that might come with its own set of risks, market risk.
Stock market returns aren’t guaranteed and can be volatile.
Life expectancy is another piece the 6% rule overlooks.
If you have a family history of longevity or are in excellent health, the guaranteed income stream of a pension could become increasingly valuable as you age.
Conversely, if you expect a shorter retirement due to health concerns, a lump sum may allow you to access or use your funds more flexibly and potentially leave more to your heirs.
And although our focus today has been primarily around financial factors, there are personal considerations that no formula can capture.
The 6% rule doesn’t know your goals, your risk tolerance, or your family priorities.
And when tailoring your retirement decision, there are times when moving beyond formulas could make sense.
The Final Word:
As with many other aspects in life, sometimes there are no perfect answers.
When we work through decisions like these with families, we try to find what matters most to them as they start to conceptualize what their priorities are.
As always, we recommend speaking with your team of trusted professional when trying to make heads or tails of what you value most.
Thanks for Reading!
Disclaimer:
Rockline Wealth Management (RWM) is a registered investment adviser located in Islip Terrace, NY. RWM is registered with the U.S. Securities and Exchange Commission. Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission.
Rockline Wealth Management does not offer tax or legal services. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.
All information presented is believed to be factual at the date of publication. This blog should not be viewed as advice for any individual and is intended for general informational purposes only.
All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client's investment portfolio.
Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. The opinions expressed and material provided are for general information and should not be considered a solicitation of financial advice or for the purchase or sale of any security.
Real-life and fictional examples given in this blog should not be viewed as guaranteed outcomes when investing. Past performance is not indicative of future results and every individual’s investment circumstances are different. Individuals should consult their financial professional before implementing their investment plan.
Certain information contained herein constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein may be relied upon as a guarantee, promise, assurance or a representation as to the future.