Pension Benefit vs Lump-Sum

If you are fortunate to have an employer guaranteed retirement benefit in a post-pension era, it’s likely you have been offered the option of a lump-sum payment or monthly benefit.

You may like the peace of mind that comes with the payments since you are assured a monthly income for life, but the lump-sum option gives you the opportunity to invest your own retirement funds, can be withdrawn on your own schedule, and can be left to your heirs after your death.

Should you take the pension or accept the buyout? The answer to this question depends on a number of factors that we’ll explore below.

Pension and Lump-Sum Example

To help illustrate the point, let’s assume you are currently a 45-year-old female and your employer is offering to pay you $2,045 per month as a single life annuity starting at age 65 through the remainder of your lifetime (your official life expectancy is around age 88). Or they are offering to pay you $145,000 in a lump-sum today.

What the Math Says

The first step is to calculate the rate of return that would make the two options equal to each other. You’ll need to use an internal rate of return (IRR) calculator to do this.

I’ll spare you the mathematical details and skip straight to the good stuff. The calculation shows that the internal rate of return is 4.72% at life expectancy. This essentially means that $145,000 growing at 4.72% per year while withdrawing $2,045 per month starting at age 65 would last for 23 years, with nothing left over — the equivalent of the monthly pension.

The longer you live, the more pension payments there are and the higher your investment return would have to be to match the pension by investing the $145,000 lump sum. Conversely, if you don’t live very long, even a return of 0% or less would be better than taking the monthly pension.

The rate of return needed on the lump sum to match the monthly pension

As you can see in the chart above, the required rates of return to replicate what the pension provides is fairly modest in this scenario.

To secure the pension payments to age 100, you would need your lump-sum portfolio to generate an average annual growth rate of around 5.30% — which is certainly achievable with the right portfolio.

If it would take an 8% to 10% rate of return on the lump sum to give you a cash flow equal to the pension payments at your life expectancy, then the pension might be a better option.

On the other hand, if a low rate of return could provide that same cash flow, you might want to go with the lump sum.

You’ll have to determine if the rate of return in your particular situation is attainable given your tolerance for market risk and other investing factors. This is something a financial advisor can help you figure out.

Other Things to Consider

While the pension payments offer some nice longevity insurance if you live past life expectancy, you’ll also need to consider the impact of inflation on the $2,045 per month payments.

Using a simple inflation-adjustment calculation, the pension payments may only equate to $977 in today’s dollars 20 years from now with 3.76% inflation, and will quickly degrade from there. This simply means that your money won’t go as far to purchase goods and services.

Value of the monthly pension after inflation

You’ll also want to keep your beneficiaries in mind when deciding between the two options. With the pension, there may not be any money that passes to your chosen beneficiaries. The lump-sum offers a little more flexibility when it comes to how the money flows to your heirs.

Another thing to consider is the financial health of your employer. If you have any concerns about the longevity of the company — or their ability to manage the pension funds — you may put more weight into taking the lump-sum now.

Finally, you’ll need to do some self-reflection and determine if you have the discipline it takes to actually make the money last throughout your retirement.

If you’re the kind of person that will use the lump-sum to take a vacation, maybe taking the monthly payments makes the most sense from a behavioral standpoint.

The pension payments provide consistent cash flow that will help with budgeting decisions and eliminates the possibility of using up that portion of your wealth while you living.

There is no one-size-fits-all solution for everyone. The specific terms of the deal and your individual situation both play a role in whether you should accept the lump-sum or wait for a monthly pension check at retirement.

Before deciding which option is right for you, be sure to work with an advisor who will provide you with the facts you’ll need to make an informed decision.