Should You Take A Lump Sum or Pension?

What To Do When Unforeseen Circumstances Force You To Make Early Decisions

For many people, retirement is something that they plan for and work towards for many years.  A lot of thought and preparation goes into retirement planning. There are numerous factors that are taken into consideration including at what age you plan to retire, how much money you will need to have saved, and how much money you will need to live. But what happens when you have a solid retirement plan in place and circumstances beyond your control require you to push your retirement plan forward earlier than expected?

According to the Employee Benefit Research Institute, almost half of retirees enter retirement earlier than they planned.  Of those early retirees, only a quarter of them choose to retire early willingly.

What To Do When You Receive An Early Retirement Offer

In their research, the Employee Benefit Research Institute found that one of the most common negative circumstances that force people to put retirement plans into action earlier than they expected are job layoffs. However, many times these job layoffs may come from companies that are looking to downsize and are offering attractive retirement packages to their employees. If you fall into this category and are offered a lump sum versus a pension, do you know which offers to accept? For many, this is not an easy decision, and the first step is to do the math to see if the monthly pension amount at least passes the “6% test.” Then, beyond the 6% test, consider how the other variables tip the scales towards a monthly amount or a lump sum.

Does Your Pension Pass the 6% Test?

To determine whether or not your pension passes the 6% test, take your monthly pension offer and multiply if by 12. Then, divide this number by the lump sum offer.

For example: $1,000 a month for life beginning at age 65 or $160,000 lump sum today?

$1,000 x 12 = $12,000 divided by $160,000 equals = 7.5%.

In this case, you would have to make approximately 7.5% per year on the $160,000 to earn a steady $12,000 a year. Earning 7.5% a year consistently and forever is a tall task, so this tells me that the monthly amount may be a better deal long term (7.5% is greater than 6%). Keep in mind, part of what a pension is doing is technically just paying you back your own money. On your own, you can withdraw 5% per year from any lump sum (even if the funds are earning 0%), and the money should last for 20 years (5% x 20 years= 100% withdraw).

Other Financial Factors to Consider

After you have done the calculations, there are a number of other factors to consider before deciding if a lump sum or a pension is right for you:

  • Your age to begin a monthly pension vs. the lump sum.
  • Your projected longevity. The longer you live the more valuable the monthly pension amount will likely be worth to you.
  • The type of pension payout you elect. Is it based just on your life and then stops after you die, or does it continue for your spouse’s life as well?
  • The solvency of the company “promising you the pension” for 20 plus years, and if the Pension Benefit Guaranty Corporation (PBGC) will back up your payments if your former company paying the pension goes out of business.
  • If you will at some point need a “lump sum” amount of money for an emergency.

Ways to Use Your Retirement Package

Only after you determine whether to take a lump sum or pension should you consider these other options or ways to use the retirement package:

Find out if it includes health care. If you don’t qualify for Medicare yet, you should learn if your retirement package includes health care. If so, this is one expense you won’t have to worry about in your early retirement.

Use the buyout to cover expenses. You could budget your buyout and use it as income until it runs out, and hold onto your retirement savings for when you truly need it.

Use the buyout to pay off debt. If you received a buyout, using this cash windfall to pay off your debts can be a good move.Pay off your mortgage, your car, or get rid of those monthly credit card balances so you can reduce your overall expenses.

Save the buyout and find a new job. An unplanned retirement doesn’t mean you have to stop working entirely.If you can find a job in your field or take on a part-time job doing something you love, go for it. This way, your retirement package is simply “found” money and can be put into your savings.

Have been offered the choice of a lump sum or a pension? If you have additional questions on this topic and other issues related to early retirement, download this guide, Unforeseen Circumstances in Retirement. If you still feel confused, the next best step you can take is to seek the advice of a qualified professional.

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For valuable financial tools and information on how to set yourself up for a happy retirement, check these out:

Social Security Optimizer, Retirement Calculator, 401k Allocator, How Do I Stack Up Quiz, Money & Happiness Quiz, and the book You Can Retire Sooner Than You Think

Disclosure:  This information is provided to you as a resource for informational purposes only.  It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors.  Past performance is not indicative of future results.  Investing involves risk including the possible loss of principal.  This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.