Like winning the lottery or receiving a large inheritance, taking your pension as a lump sum comes with the danger that you’ll spend the money too fast.
“Retirees see a lump sum as a big pile of money rather than income they’re going to need for the rest of their lives,” says Steve Anzuoni, a retirement income certified professional and owner of Fairway Financial Insurance Agency in South Yarmouth, Massachusetts.
Although less common than 401(k)s and similar workplace plans, pensions are far from obsolete. The Bureau of Labor Statistics estimates that 15 percent of private sector workers and 75 percent of state and local government employees participate in a traditional pension plan. When these employees retire, they can choose to receive their pension as either an annuity or a lump sum.
If taken as a lump sum, the money can evaporate. According to MetLife’s 2017 Paycheck or Pot of Gold Study, one in five defined benefit and contribution plan participants who took a lump sum have already depleted it. On average, it took just 5.5 years for lump sum recipients to exhaust those funds.
[Read: How to Avoid Tanking a Portfolio in Retirement.]
If you’re banking on a pension lump sum for retirement income, that’s a mistake you can’t afford to make. To make the best use of that money, you’ll need to do some soul searching and crunch some numbers.
Motivation. Retirees opt for a lump sum over an annuity for several reasons. Some choose the lump sum because they feel the money is worth more when it’s in their hands, an emotion-based decision, Anzuoni says. Others may want to use the money to pay down credit cards or eliminate a mortgage, and many simply believe they can manage the funds better themselves.
“Most individuals would rather create their own personal pension and leave remaining assets to their children, grandchildren or charities,” says Gage Kemsley, vice president at Oxford Wealth Advisors in Rio Rancho, New Mexico.
If invested wisely, a lump sum may yield a higher return rate than an annuity while potentially providing better insulation against inflation. It can, however, be problematic.
“People want to control their money, which can sometimes be a big mistake,” says Matthew Archer, founder and managing partner at Archer Investment Management in Raleigh, North Carolina.
Archer says retirees may take a lump sum without fully understanding their options for putting that money to work. In the worst-case scenario, they may end up rolling those funds over into the wrong investment products, incurring higher fees and reducing liquidity.
If you’re leaning toward a lump sum, ask yourself what your motivation is. If you want to pay off debt, for example, consider what the long-term financial benefit would be instead of using the money to expand your investment portfolio.
Longevity. In the MetLife survey, the average age of pensioners who took a lump sum was 65. The average age at which they expected the money to run out was 82. According to the Society of Actuaries, however, 25 percent of people age 65 today will live until they’re 95.
[Read: Today’s Investors Are Too Conservative.]
For a lump sum to last 30 years, retirees will have to pace themselves, says Terry Dunne, managing director of retirement services at Millennium Trust Company in Chicago.
Unfortunately, “many people who take lump sums make the mistake of paying taxes too early or spending too much, too soon,” Dunne says.
Lump sum distributions are generally taxed as ordinary income unless you roll the money over into an individual retirement account. That allows the money to continue growing tax-deferred while plugging any potential income gaps from your other retirement assets.
Depending on the scenario, Kemsley says, a pension lump sum can be combined with other retirement assets to generate a monthly income similar to a life annuity. This mimics the security of an annuity’s lifetime income stream while still giving you flexibility and control over how pension funds are used.
Jeff Kletti, head of investments at Wells Fargo Institutional Retirement and Trust in Minneapolis, says retirees should consider three financial questions before taking a lump sum.
“First, what is their target retirement income need? How much of that is covered by Social Security, their pension plan or income from their retirement portfolio? Finally, what’s their risk tolerance?” Kletti says.
He acknowledges that the decision is essentially a trade-off between retaining control and potentially increasing lump sum assets, versus the certainty of an income stream. “People fall on different spots within that spectrum, and that’s what’s going to drive the decision,” Kletti says.
Strategy. Opting for a lump sum without a plan for how the funds should be used could set you up for failure.
Besides your age and risk tolerance, that strategy should consider your expected spending in retirement. Too often, Kletti says, people don’t estimate their spending accurately or understand how that corresponds to an appropriate draw-down rate, which “can present a real problem for a person managing a lump sum payout and needing to make it last.”
Whether someone is married or has health issues also factors in to that decision.
“If you’re not in great health, taking a lump sum may be a better option for passing funds on to your family,” Archer says. “Ask yourself if you take the lump sum now, will you have needs later on and if so, how they’ll be filled.”
Get professional help if you’re unsure how to make the money last.
“Retirees really need to sit down with a qualified advisor to figure out their income needs,” Anzuoni says.
[See: Your 7-Step Checklist to Choosing a Financial Advisor.]
A financial advisor can address different scenarios, such as how changes in interest rates may affect returns and cost of living, when to begin taking Social Security benefits, or how a surviving spouse should manage retirement assets.
“Decisions can’t be made lightly, emotionally or quickly,” Anzuoni says. “We need to look at the numbers and goals together to make the best plan.”
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