Lump Sum Cash Out vs. Monthly Annuity Pension

By Christopher L. Hudson, Financial Advisor, CIMA

Already faced with a number of critical decisions regarding the disposition of their 401(k) Savings Plan (roll the money into an IRA account, keep the money inside of the company plan, take possession of the money directly as a taxable event or roll the balance into your new employer’s plan if allowed) – many of our clients are faced with the additional decision of how best to handle their defined benefit pension as well. Should they take it in the form of a monthly annuity for life or as a single lump-sum cash out upon leaving their company?

Although everyone’s situation is unique – we have found there are several common factors that employees need to consider when making this decision.

1. Interest Rates: The level of interest rates in the economy has an impact on the value of a lump-sum cash out. Many companies use the GATT Rate, PBGC Rate, 10yr. Treasury yield, or some other interest rate in the calculation of a lump-sum distribution. The higher the interest rate used in the calculation – the lower the value of your lump-sum cash out will be (all other things being equal). In higher interest rate environments, the value of your lump-sum cash out may not look as attractive as taking the monthly annuity pension. In times of low – or falling – interest rates – you will see an increase in the value of your lump-sum pension relative to the monthly annuity. The current level of interest rates – and the level of rates in the future when you are contemplating transitioning into retirement – are one factor in making an informed decision.
2. Life Expectancy: The longer you live – the more monthly checks will have to be sent out by the company as almost all monthly annuity pensions are paid out for the life of the employee (and possibly the life of the employee’s spouse as well if the joint life option is chosen). If you have longevity in your family – and your retirement could last as long as 25 or 30 years – you may consider taking the monthly annuity option which provides a monthly check for the remainder of your life no matter how long you live. One additional factor to consider in this scenario is inflation. Most corporate pensions do not provide a cost-of-living (COLA) increase in retirement.
3. Inflation Risk: As mentioned above – most corporate pensions do not provide an annual cost-of-living (COLA) increase to the recipient so the impact of inflation has to be taken into consideration with an annuity pension. At a 3% annual rate of inflation – your costs in retirement will double every 24 years. At higher rates of inflation – your costs will increase at a more rapid rate. Taking a lump-sum on the other hand – may provide an opportunity to allow your retirement assets to grow at a rate that exceeds the rate of inflation if invested appropriately. 

4. Market Risk: Typically when an employee takes a lump-sum distribution – and rolls the proceeds into an IRA account to avoid taxation – it is then invested in the market as part of their overall retirement portfolio subjecting the balance to market volatility. Typically a monthly annuity check is used to cover immediate living expenses and is therefore not affected by the market.

While monthly pension payments may be immune from market swings – the solvency of the company - and by proxy the pension assets themselves - may not. Thus – it is a possibility that future pension payments could decrease if the underlying plan is underfunded or performs poorly.

5. Comfort: One of the biggest aspects of retirement is comfort. Some individuals may simply feel more comfortable receiving a check every month from their former employer versus managing the money and investing it in the markets. Others may feel very different and prefer to receive their pension in the form of a lump-sum where they have the opportunity to invest the funds and hedge against the long-term impact of inflation. Either way – it is important to look at all of the factors and make the decision within the context of a comprehensive – long-term –plan.       

Any opinions are those of Christopher Hudson and not necessarily those of Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Asset allocation and diversification do not guarantee a profit nor protect against a loss. Raymond James and its advisors do not offer tax or legal advice. You should discuss tax or legal matters with the appropriate professional.

Be sure to consider all of your available options and the applicable fees and features of each option before moving your retirement assets. When reviewing defined benefit distribution options, it's important to work closely with your financial advisor to carefully consider the multiple factors impacting your decision and determine the option that will best suit your long-term needs. This will include weighing the pros and cons of each payout option within the context of your financial plan. You may also want to collaborate with other professionals, such as your tax advisor and attorney, for additional insight.