Should You Take a Lump Sum or Pension?

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

Envelope filled with cash

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Many people spend years planning and working toward their retirement. They carefully craft their plan based on factors like the age at which they hope to retire, how much money they will need to live, and how much money they will need to have saved. But what happens when you have a solid retirement plan in place and circumstances beyond your control push your retirement plan forward earlier than expected?

It's a fairly common scenario that everyone should be prepared to face. 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 willingly chose to retire early. If you find yourself among them, you'll have to make some important decisions.

A Common Early Retirement Scenario

In their research, the Employee Benefit Research Institute found that one of the most common negative circumstances that force people to alter retirement plans are job layoffs. However, these job layoffs could come from companies that are looking to downsize. In that case, the company may offer attractive retirement packages to employees close to retirement.

If you fall into this category, you may have to choose between a lump sum and a pension plan. This is not an easy choice, but there are steps you can take to feel confident in your decision. The first step is to crunch some numbers and learn more about your choices. After that, consider how the other variables tip the scales towards either a lump sum payout or a monthly pension payment.

The 6% Test

Most people who take the lump sum invest at least a portion of it so the money can grow and bolster their retirement savings. The 6% test is a way of gauging whether the lump sum is significant enough to grow at a rate that resembles pension payments.

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

As an example, let's consider a scenario in which a retiree is asked to choose between $1,000 a month for life beginning at age 65 and a $160,000 lump sum payment today. A $1,000 monthly pension payment multiplied by 12 equals $12,000. Divide $12,000 by $160,000 and you get 7.5%.

The person in this scenario would have to earn approximately 7.5% per year on the $160,000 to mimic the steady monthly payments of the pension plan. Earning 7.5% a year consistently is a tall task, especially since retiree investments are on a relatively shorter timeline. That means the monthly amount may be a better deal in the long-term.

As a rule of thumb, it's more realistic to expect your lump sum to earn less than 6% per year in investments. If you can earn less than 6% and still make more than your pension plan payments, the lump sum payout may be your best bet.

Keep in mind, part of what a pension plan does is technically just paying you back your own money. On your own, you can withdraw 5% per year from your total pension funds, and the money should last for at least 20 years.

Other Financial Factors to Consider

The calculations are an important step, but they're only the first step. After you do the math, there are several additional factors to consider before deciding if a lump sum or a pension is right for you:

  • Consider the age when your monthly pension payments begin versus when the lump sum pays out.
  • How much longer can you realistically expect to live? It's a bit morbid to consider this one, but it's a crucial piece of retirement planning. The longer you live, the more valuable a lifetime monthly pension plan becomes.
  • Consider the details for your pension plan. Is it based just on your life and then stops after you die, or does it continue to cover your spouse’s lifespan?
  • How stable is the company “promising you the pension?” If you're worried about the pension company going out of business, look to see whether the plan is backed by the Pension Benefit Guaranty Corporation (PBGC), which helps guarantee your income.
  • Take stock of your entire financial portfolio, including any additional forms of retirement savings. Then, consider whether this amount is sufficient to cover any sudden emergency payments. If not, that could be another benefit to taking the lump sum payment.

Ways to Use Your Retirement Package

After you have a good idea of whether you're going to take the lump sum or stick with a pension plan, consider some common ways people use their retirement funds. These shouldn't be primary factors in your decision, but they can help you clarify your retirement plan.

Find out if your retirement package includes health care. If you don’t qualify for Medicare yet, you should learn if your health care expenses will be covered under a retirement plan. If so, this is one expense you won’t have to worry about in your early retirement. If not, make sure you set aside funds for health care costs.

Use the buyout to leave savings alone. You could budget your buyout to use it as income until it runs out. That way your retirement savings will remain untouched for when you truly need them.

Use the buyout to pay off debt. Using the cash windfall from a buyout 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. Doing so all at once, and early on in retirement, can save you on interest expenses, as well.

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 that can be put into your savings.

The Balance does not provide tax, investment, or financial services and advice. The information 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.