Pension payment: Lump sum or monthly check?

Count yourself fortunate if you work for an employer that offers a traditional defined-benefit pension plan, which is an increasingly rare bird these days. In this case, when it comes time to retire, you might be offered the option to receive your pension benefits in one lump sum instead of getting lifetime monthly pension checks. Or you may participate in a hybrid defined-benefit plan called a “cash balance plan,” most of which also offer the choice of a lump-sum payment.

If you’ve worked many years for this employer and have earned a substantial benefit, deciding between the lump sum and monthly pension will be one of the most important financial decisions you’ll make about your retirement. It’s well worth your time to carefully consider your choices before doing so.

In most cases, your election is irrevocable. So if you choose the lump sum, you permanently forfeit the right to receive a lifetime monthly check. Similarly, if you elect the monthly payment, you can’t change your mind and elect a lump sum later.

Fortunately, help is available regarding this complex decision. The Society of Actuaries (SOA) recently published a very helpful brief titled “Lump sum or monthly pension: Which to take?” as part of its “Managing Retirement Decisions” series.

The SOA focuses on older workers who are approaching retirement. But many younger ones are being offered the chance to cashout their deferred pension for a lump sum, and many of the considerations in the SOA brief are the same for them.

It’s important to point out that the SOA doesn’t advocate for a particular decision. Instead, it urges you to make a careful analysis before choosing. You should start your analysis many months before your retirement date. Don’t put it off until the last moment and make a hasty decision you may regret later.

Pros and cons

The SOA does a good job of summarizing the benefits and drawbacks of each decision. In a nutshell, the primary advantages of the lifetime monthly pension are:

• You receive a fixed payment no matter how long you live. How long you'll actually live is one of the biggest challenges of retirement planning, and the lifetime monthly pension neatly addresses this challenge.
• Your monthly check won’t be reduced if the stock market performs poorly.
• You don’t need to make any decisions about how to invest your money or how much to withdraw. You’ll appreciate this feature when you reach your 80s and 90s, and may have less ability or interest to manage your finances.
• You don’t need to worry about being defrauded -- employers must act as fiduciaries when they operate your pension plan, and they must comply with strict federal pension laws.

The primary advantages of the lump sum are:

• You’ll have access to the full amount in case you have an emergency or your life circumstances change.
• You may achieve favorable investment returns if you invest the lump sum.
• Upon your death, any unused money is available for an inheritance.

The primary disadvantages of the monthly pension are that you don’t realize the advantages of the lump sum. Similarly, the primary disadvantages of the lump sum are that you don’t realize the advantages of the monthly pension. 

It would be nice if a pension plan would allow you to get the best of both worlds by splitting your decision, taking part of your benefit in a lump sum and the rest in a monthly pension. Unfortunately, most plans offer you an “all or nothing” choice.

If you think you’ll want to elect the lump sum and use it to generate a monthly income, you’ll want to estimate the income that’s reasonable to expect. Often the monthly income offered by the pension plan is higher than the monthly income you can generate by investing the lump sum. You should also know that you’ll typically have to assume stock market risk to generate a higher income.

Making your decision

Here’s one plan for helping you choose which route to take: Develop enough guaranteed, lifetime income to cover your basic living expenses in retirement -- mortgage, food, utility bills, insurance, transportation and so on. This way, if you live a long time or the stock market crashes, you won’t run out of money and need to move in with your kids.

If your Social Security income alone covers these expenses, you may not need the monthly pension. In this case, you could elect the lump sum and invest it to cover your discretionary living expenses, such as travel, hobbies, gifts and spoiling your grandchildren.

However, if you need more than Social Security to cover your basic living expenses, you may want to elect the monthly pension instead. By the way, if you still fall short  of your basic income target, you may need to use other savings to buy a guaranteed lifetime annuity​ from an insurance company.

With this strategy, once you’ve covered your basic living expenses, you can invest the rest of your savings and use a systematic withdrawal plan​ to cover your discretionary expenses.

Do your homework

The SOA brief contains a more extensive list of the pros and cons of each approach, along with checklists that describe when each election might make sense. It has an extensive example of the homework that one couple did to make their decision, as well as their reasons. It also links to another SOA brief that provides information on finding a qualified, unbiased adviser who can help you with this choice, should you need professional assistance.

Your future 80- and 90-year-old self will thank you for putting this effort into making a careful decision.