Employees with a defined benefit pension may have the opportunity to receive a one-time, lump-sum benefit instead of a monthly retirement benefit for life.
When making this decision, a number of factors should be evaluated, including the lump sum, the amount of monthly payments, and the recipient’s age at the time the offer is made. Other factors to consider include the recipient’s health, whether the pension will benefit the surviving spouse, and the recipient’s level of financial literacy, self-discipline, and need for financial flexibility. When faced with such a choice, a financial advisor can help you evaluate your options and make an informed decision.
Lump sum versus monthly payments
A retiree who is paid $250,000 in a lump sum instead of $2,750 monthly payments for life can begin calculating the potential cumulative value of the monthly payments. To do this, they must estimate how long they are likely to live.
According to Social Security life tables, a 60-year-old man has an average life expectancy of about 20 years. If the pension starts paying out at age 65 and continues to do so until the beneficiary dies in 15 years at age 80, he will collect approximately 180 monthly payments for a total of $495,000.
If the beneficiary chooses the lump sum instead, he can immediately start investing it at the age of 60. When he retires five years later, he can withdraw $2,750 monthly. To sustain the $250,000 until he turns 80, his investments would need to earn an average annual return of at least 5.9%.
Now suppose the retiree is a 55-year-old woman and her monthly payments begin at age 65. According to the Social Security Administration, she can expect to live to age 83. In this case, the monthly payments have a slightly higher value, amounting to $594,000. However, because the lump sum is invested for a longer period of time before she starts withdrawing, her investments only need to grow at an average of 4.84% per year for her to use the money until age 83.
In both scenarios, the required return for the lump sum payment, which is at least equal to the value of the monthly payments, is not unreasonable. It’s possible for a well-managed portfolio to exceed these average returns, making the value of the lump sum option greater than the monthly payments.
As you can see, decisions like these often require some calculations and assumptions. A financial advisor can help you crunch the numbers and weigh your options.
Other Considerations
In reality, the choice between a lump sum or a monthly benefit will likely be a little more complicated than these simplified scenarios. For example, many pensions have a survivor benefit whereby all or part of the retiree’s benefits are paid to the surviving spouse after the retiree’s death. If a spouse outlives the original pension recipient, this can significantly add to the value of the monthly benefit option.
Ultimately, the lifespan is of course not assured. If a monthly benefit recipient dies earlier than expected, this reduces the value of the monthly benefit. If they live longer than expected, the value increases. For this reason, details about the recipient’s health can be important considerations. Someone who is in good health and has a family history of living to an older than average age may place a greater value on the monthly payments.
Inflation and investment returns are two other unpredictable factors. While 7% may be seen as a reasonable expectation for average annual returns based on historical investment data, there is no guarantee that future performance will match that. Likewise, if inflation rises, the purchasing power of a monthly benefit will decrease unless the cost of living is adjusted to match the pension. Investing a lump sum offers the opportunity for returns that can help overcome the purchasing power erosion caused by a period of rapid inflation.
Safety is an important consideration when it comes to paying for your pension. Pensions are guaranteed, but investment returns are not. A recipient who does not have the financial knowledge to sensibly invest a lump sum may be better off with a monthly benefit. Likewise, a person who is given a large sum of money may spend it frivolously instead of investing it wisely to pay for living expenses in retirement.
While taking a lump sum can be inherently riskier, it also offers flexibility that can be an advantage in some situations. For example, if someone has significant debt, it may make more sense to take the lump sum and pay off what is still owed, rather than continuing to pay off the debt while receiving monthly benefits.
If you are facing a similar decision or scenario, consider discussing it with a financial advisor first.
In short
When choosing between taking a lump sum or receiving monthly pension payments, the main factors to consider include the age of the pensioner at the time the offer is made, the life expectancy of the beneficiary and the amount of the fixed amount and the amount of the monthly pension benefits. payment. Other factors to consider include details about the pension, including whether it offers spousal benefits or inflation adjustments.
Retirement planning tips
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A financial advisor can bring objectivity, experience and insight when assessing the choice between monthly pension benefits and a lump sum. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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SmartAsset’s Investment Return and Growth Calculator provides a quick, easy and free way to see how much your portfolio could be worth in the future. This can be useful if you receive a lump sum pension and want to reinvest it in the stock market for a number of years.
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The post Should I take a $250,000 lump sum or $2,750 monthly payments for my retirement? first appeared on SmartReads by SmartAsset.
