The question many retirees face as they approach retirement,

“Should I take a pension or the lump sum?”

Allow me to provide some context:

A pension refers to a stream of income, generally based on your salary, which you can receive in retirement as lifetime income.

A lump sum is a one‑time payment, usually rolled into an IRA, and managed as an investment portfolio to generate retirement income.

Choosing between the two options is often a very difficult decision.  There are a number of different web sites and podcasts that would take you through the steps of evaluating the math, measuring risk tolerance, choosing investments, comparing and contrasting the two options.

 

 

That can all get pretty wordy and confusing and I think I can save readers a lot of trouble by approaching the question a different way.

The funny thing about financial planning and investing is that you can have two people with identical numbers and in identical situations and have completely different recommendations, everything else held equal.

For us, the decision to take a lump sum or lifetime payments would be prefaced by the simple question, “What are your priorities?” 

“What are your priorities?” 

If leaving assets to your heirs is your number one priority, you’re going to have a different approach and a different thought process than someone who is afraid of running out of income in retirement.

Many people might regard both of those options as somewhat important but what we really need to do is rank priorities and that will guide our decision making.  Rather than looking at the numbers and trying to do a lot of “guesstimating” based on how long we’re going to live and what investment returns might be, I think ranking these seven priorities might guide us in a direction that the math couldn’t.

This is an important decision that clients are going to make.  It’s a decision that they might have to deal with for 30 years.  So it’s important to take every item possible into account.

The other difficult thing when we’re talking about deciding between a pension and the lump sum is conflict of interest.  If you’re not hearing your financial advisor mention conflicts of interest when giving his investment recommendations, you should know that you are in trouble.

The thing is, financial advisors are compensated by either the purchase of a product, by the management of assets, or potentially a combination of both.  The first thing I would recommend is that they talk to a fee‑only financial planner, e.g.: a financial planner that doesn’t work for any type of product commissions.  Any advice that you execute that they recommend for you is going to be based on a flat fee that you negotiate ahead of time.  Sometimes that’s an hourly fee, sometimes that based on assets under management, but the planner isn’t going to be compensated by selling you a life insurance policy or variable annuity or some sort of front‑end loaded mutual fund.

“Talk to a fee-only planner”

You can learn if your financial advisor is fee‑only by going to NAPFA.org, that’s the National Association of Personal Financial Advisors.  Others would be cfp.net. or letsmakeaplan.org where you can find out who’s a certified financial planner in your city and sort the results by how they are compensated: commission, commission and fee, and fee‑only.

Beyond that, if you are compensating a planner to manage your assets while you’re making a decision between a pension and a lump sum, keep in mind that even if the financial advisor is fee‑only, there is still a conflict of interest that exists because if you were to take the lifetime payments there wouldn’t be any assets to manage.  You can see that there would be a natural conflict of interest that is involved because your advisor, weather he’s acting in your best interests or not, if he instructs you to roll your pension into this IRA that he’s going to manage, that’s a conflict of interest.

Not that conflicts of interest are a deal-breaker, but they need to be acknowledged.  Letting the client know the conflict exists allows the client can make an informed, educated decision without feeling like they are being specifically led one way or another just to compensate the advisor.

Moving on to the priorities, these would carry differing levels of importance for different people.  You might rank one far above the other, but these are seven things that pre-retirees should consider before you even think about the numbers.

Lifetime Income 

Upon retirement many retirees are faced with the following question:  Take the lump sum payment from my pension or take lifetime monthly payments also known as an annuity?

(I’ll probably use those three labels interchangeably:  Annuity, pension, lifetime income, they all, basically, mean the same thing.)

Let’s unpack that a little bit.  What does lifetime income mean?  Essentially, the company you worked for whether it’d be a municipality or a large corporation, is going to pay to you an income for life.

There are many versions of lifetime income.  If you’re married, you can choose between  lifetime income, like a joint life, also called 100 percent joint and survivor.  As long as you or your spouse are living, payments will show up every month.  There are many different variations.  Single life, meaning that once you die, even if your spouse is still living, the payments stop, and there are halfway points in between, like 50 percent joint and survivor.  So whoever the first spouse is that passes away, the benefit will be reduced by 50 percent and payments will carry on.

What we’re really talking about is the transfer of risk.  If you want to bear a lot of risk on yourself as a single‑life payment, that will give you your highest payment.  If you want to bear a lot of risk on the company or the insurance company, then that would be 100 percent joint and survivor.  That’s going to give you the lowest payment but it’s going to get the maximum length out of the payment.  If either you or your spouse live until a very advanced age then you’d get a substantial amount of money from the plan.

If Lifetime income is your number one priority versus the other six, you’re going to want to rank that accordingly.

Risk

Put simply, if you are considering a lump sum there is going to be some level of risk to be managed.  Taking a lump sum if you plan on living for 20, 30 or more years, if you are completely risk averse, if investing in CDs and money market instruments is your style of investing, you’re going to have a tough time with the lump sum because there’s going to be assets that need to be managed.  If you want to have a ‑‑ there’s no such thing as a risk‑free plan, but if you want to hapension or lump sumve a very low‑risk plan, you’re probably going to want to rank risk as a higher priority item which is going to push the lump sum down a few notches and push lifetime income up a few.

Weather you are massively risk averse or are able to take some risk, is going to mean very different things when we talk about lifetime payments, versus a lump sum to manage.

Questions to ask yourself:  Are you risk averse?  Are you able to handle risk?  How did you feel in 2008?  How did you feel in 2000?  How did you handle that?  Were you able to stick to a plan? 

If you weren’t able to stick to a plan, you would want to rank that fairly high that you want a risk averse plan which would naturally lead you to lifetime payments.

Lifestyle Flexibility

Lifestyle Flexibility is the most overlooked priority. This is a big deal.  Some retirees have a very even keel spending style.  Perhaps their pension is going to provide for most of their needs and they don’t have any grandiose plans.  We have some clients that want to see the world, clients that want to take their grandchildren to Disney Land and want their financial plan to account for that.

“Go-go, Slow-go, No-go”

We have a phrase that we often say to clients is that some people have in their mind a three‑stage cycle of retirement.  They have the go‑go years, the slow‑go years, and the no‑go years.  The go‑go years meaning, let’s say the first ten years of retirement I’m going to see the world, I’m going to have a second home, I’m going to travel the country to visit grand kids, that is naturally going to have a higher price point than their normal working years.  If they’re traveling several times a year or if they’re making larger purchases, that’s simply going to cost more.

The slow‑go years are often the next ten years of retirement.  Again, this isn’t for everyone.  The next ten years are the slow‑go years.  They’re starting to slow down a bit.  They haven’t completely stopped with their lifestyle but they have slowed down quite a bit.

The no‑go years are the last ten years.  So we have first ten, go‑go; second ten, slow‑go; third ten, no‑go.  And if we kind of draw a line and make an average, the go‑go years are above the line, the slow‑go years are at the line, and the no‑go years are below the line.

So, if this is part of your plan where you want to spend more than your normal lifestyle early on and then want to account for that with spending much less than your normal lifestyle later on, a lump sum would better suit you .  There simply wouldn’t be enough money early on if you took the pension because you can’t fast forward those payments.  Pension payments are based on your life expectancy, so it’s inflexible, there’s no way to increase it or decrease it, speed it up, slow it down.  They’re going to send you a check on the first of the month for as long as you live.  There’s no way to create the flexibility that could be a high priority for some people.

So if you want lifestyle flexibility, you’re going to want to rank a lump sum slightly higher or maybe substantially higher depending on your goals than lifetime payments.

Longevity Fears

When we’re talking about pension versus lump sum, one option will absolutely will hedge against longevity and one potentially won’t.  If longevity is a concern of yours, we’ll need to consider that.

Do you have substantial longevity in your family?  Do you have 100‑year‑old aunts?  98‑year‑old uncles?  What about the opposite, perhaps everyone in your family died at 65?  If that’s the case, lifetime payments would probably be a bad decision for you.  None of us know when we’re going to die, but I think anybody would hate to leave substantial amounts of money on the table if you are relatively sure you’re not going to have a long retirement.  If you’re certain you’re only going to make it 15 years in retirement, that might lead you down the road to a lump sum.

Longevity fears work both ways.  If you are desperately scared of living too long or you are positive that you won’t achieve old age, depending on your priorities and how you feel about your own situation, that’s going to dictate how we rank these priorities.

Mathematically speaking, if you take a lump sum, no matter how good your financial plan is or how talented your investment manager is, if you go back to that well (so to speak) enough times you’re going to bring your bucket up and it’s going to be dry.

This can’t happen with lifetime payments because they are payments based on your lifetime.  So whether you make it until 89, 99, or 109, if it is a big concern of yours about longevity and you’ve got a lot of longevity in your family, you’re going to want to rank longevity concerns a little bit higher.

Surplus to Heirs

How badly do you want to leave money to your heirs?  If that’s a high priority, that points in favor for the lump sum.  If it’s a low priority, points in favor for the lifetime income, the pension.

The strongest part of an annuity is that it is a lifetime payment, but depending on your goals that could also be its weakest point.  If a big goal of yours is to leave some money to your heirs, lifetime payments won’t cut it.  Simply put, when you die, the income stream dies. This is why we’re not going to crunch too many numbers in this article because depending on your stated priorities, the exact goal of annuity (lifetime payments) could be the best part or the worst part of the financial plan based on your specific goals.

“I want the last check I write to bounce!”

Many clients make the joke, “I want the last check I write to bounce!”  If this is your genuine intent, the annuity would simply be terrible at this, you would want the lump sum.  We have some clients that actively reduce their lifestyle in retirement because they want  to help their children or their grandchildren or a charity they care about.

This cannot be done with an annuity, but it can be done with a lump sum.  There is still potential for failure even if a surplus is your goal because, again, if you live too long, there won’t be any surplus.  But if you sit down with a financial planner and map it out and there’s a strong chance that there’s going to be a surplus, you’ll have to decide if you want to put faith in those projections, but if it looks like there’s a large surplus, a lump sum would probably be better than the pension in that case.

Fear of Inflation

Lifetime payments are very rarely indexed for inflation.    Meaning that the monthly amount in 2015 dollars might support your current lifestyle but as inflation slowly eats away at the purchasing power of your 2015 dollars, it could have an impact later on in retirement.  Inflation isn’t something that you’d feel right away, but let’s look at a $5,000 monthly income at 3 percent inflation.  At 3 percent inflation, in ten years $5,000 is going to feel like $3,700 dollars.  In 20 years, $5,000 is going to feel $2,700, and in 30 years $5,000 is going to feel like $2,000.

We’re going from $5,000 to $3,700 in ten years, $2,700 in 20 years, and $2,000 in 30 years.  When we go from $5,000 to $2,000 that is a huge reduction in purchasing power.  Can your retirement budget account for that?

We don’t want to concentrate too much on the math because it’s hard to prioritize goals around math.  Math is black and white, right or wrong.  So if we sit down with a client and only focus on the math, we could be dictating to them what they should do.  But if we’re not accounting for what their specific goals are, we aren’t really financial planning, we are financial dictating and not really helping anyone.  We’re doing a math calculation for them they could easily do on Google.  This is where my inner life coach kicks in and says let’s not look at the math first, let’s prioritize because based on your priorities there might not be any math involved at all.

I could sit down with a client and say we’re going to do some fantastic investment management for you, we’re going to build this amazing Retirement Runway based on all these assumptions and we are going to be 98 percent certain after running this Monte Carlo analysis that you’re going to have a large surplus, sign here Mr. Client or Mrs. Client and this is exactly what we should do.  But if the client factors a low‑risk plan higher than that surplus or if they factor lifetime income over that surplus or if I haven’t asked enough questions and she’s got three aunts that are 105 years old and that’s a huge concern of hers that keeps her awake at night. I’m focusing on a surplus that might only be important to me, the financial planner, and it isn’t even my plan.

“Priorities should speak louder than numbers”

Everyone should have a little healthy fear of inflation because we call that going broke slowly.  If you live long enough inflation will impact your plan.  It will impact it severely.  But if that’s not a huge motivator for you, then you would want to go more towards the pension.  If it is a fear of yours, you would want to probably guide yourself more towards the lump sum.  You’d want to hypothetically invest in more of a stock‑based portfolio and attempt to outgrow inflation.

Again, we don’t want to talk too much about investments because this is more about ranking priorities, but fear of inflation is something to consider and rank accordingly.

Simplicity or Ease of Execution

Managing the lump sum can be complex.  Essentially, your company is going to write you a check for potentially several hundred thousand dollars, or even millions and that needs to be managed in some way.  Unless you want to pay income tax on that entire amount year number one of retirement, which you probably don’t, you’re going to want to roll those funds into an IRA and manage it from there.  You’re going to drip it out monthly, slowly take those payments and just that in and of itself is a plan that needs to be managed.

Managing the lump sum can be complex.  You’d have to learn about managing investments or you’d have to hire a professional which isn’t free.  That can get very expensive.  Some financial advisors charge two or three percent per year on a million dollars.  You’re talking a substantial amount of money, maybe even more than you were planning on taking out in a given year.  And hopefully this is all disclosed to you ahead of time by your financial advisor and I think most of the time it is but it’s something to consider.

Maybe one of your top priorities is just a simple plan that you don’t want to worry about.  Many clients have had a 401K for the last 20 years and the market fluctuations were more than they could bear and they didn’t want to deal with that anymore in retirement.  They’d rather hit a golf ball around or take a cruise or whatever that might be.  That attitude would be a detractor from the lump sum, thus a natural promotion for the lifetime payments.

Do you mind a complex plan?  Do you mind meeting with a financial advisor two, three, four times a year?  If you don’t mind, then lump sum might be a better fit.  If that is something that inconveniences you and you don’t want to think about it too much, lifetime income is as simple as simple can get.  All you’ve got to do is walk out to the mailbox once a month and grab that check.  Pretty simple.

In conclusion, take your time and prioritize choices one through seven, you need to rank these for yourself individually.  If you are married you need to have this conversation as a couple.

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