Pensions: lump sum versus monthly

In short

A friend of mine sat at his kitchen table last spring with two offers from his old employer. One was a check for a big sum. The other was a smaller payment every month for life. If you are holding the same two choices, take heart, because you can work this out. Start by asking the plan for both offers in writing, along with the interest rate it used to figure the lump sum. Then ask what a plain monthly payment for life would cost you on the open market. Check whether your pension has any cost of living raise, and whether your spouse would keep getting paid if you died first. Do not sign until you know what you would give up either way.

The whole of it

What it is

I once watched a retired teacher spread her pension papers across a card table like a hand of solitaire. She had two piles, and she could not make them agree. A pension is a promise from a former employer to pay you in retirement. Many plans let you pick how to take that promise. One way is a lump sum, which is one payment now for the full value of the promise. The other is an annuity, which is a steady payment, often monthly, that lasts as long as you live.

The two choices solve different problems. The lump sum hands you control and puts the risk on your shoulders. The monthly check hands the risk to the plan and takes your control away. Think about which of those two trades sits easier with you.

How it works

If you have ever wondered how a plan turns a monthly promise into one big number, you are asking the right question. The plan uses a discount rate. That is an assumed interest rate used to shrink future payments into today's dollars. A higher rate makes the lump sum smaller. A lower rate makes it larger. Rules set by federal law govern which rates many private plans must use, and the Internal Revenue Service and the Department of Labor both publish guidance on this. Ask your plan which rate it picked and where it came from.

Taking the monthly check has its own choices. You can take a single life payment, which is the largest and stops when you die. You can take a joint and survivor payment, which is smaller but keeps paying your spouse after you are gone. ERISA, the main federal law covering private pensions, generally requires married people to get spousal consent before they give up survivor benefits. Your plan's summary plan description spells out the details.

Now the tax side. A lump sum that lands in your bank account is generally taxed as ordinary income all in one year. That can push you into a higher bracket. But you can often roll the money into an IRA, which is a personal retirement account, and pay no tax until you take it out. A direct rollover, where the plan sends the money straight to the IRA, avoids withholding trouble. Monthly checks are taxed as ordinary income as they arrive. See IRS Publication 575, Pension and Annuity Income, for the rules.

One more piece matters a great deal. Many private pensions are insured by the Pension Benefit Guaranty Corporation, a federal agency. It covers benefits up to a limit if a plan fails. Check its website for the current figures. A lump sum rolled into an IRA leaves that insurance behind. You take on the job of making it last.

The numbers, and where to find yours

You have probably got a stack of paper from the plan, and the answers are in there. Look at your benefit estimate statement. It should show the monthly amount at your normal retirement age, the lump sum value, and the reduced amounts for early retirement or for a survivor option. If it does not, call the plan administrator and ask.

Three outside numbers help you judge the offer. The first is the price of a similar annuity. You can get quotes from insurance companies and compare them to the plan's monthly amount. The second is the age when required withdrawals start from an IRA, which is the current figure, which the official source publishes each year. The third is the most the Pension Benefit Guaranty Corporation covers, which is the current figure, which the official source publishes each year. Each year the site fills in the verified figure and its source.

Also find out if your monthly payment grows with prices. Many private pensions do not raise the payment each year. Some public pensions do. A check that never grows loses buying power over the years. Cost of living matters more the longer you live.

A worked example

I know a woman named Denise who worked twenty years at a regional manufacturer and left at age 62. She had two offers from the plan. The first was a lump sum of 240,000 dollars. The second was 1,300 dollars a month for life, with no raise and no survivor benefit.

Denise wanted to see what the lump sum would have to earn to match the check. First she found the yearly income from the pension. That is 1,300 dollars times 12 months, which equals 15,600 dollars a year. Then she divided that yearly income by the lump sum. That is 15,600 divided by 240,000, which equals 0.065, or 6.5 percent. So she would need to pull out 6.5 percent of the lump sum each year, every year, to copy the pension.

That number told her something. Pulling out 6.5 percent each year is a big bite. If her investments earned less than that, the pile would shrink. If she lived a long time, it might run dry. The check, on the other hand, would never run dry.

Then she looked at what she gave up. The lump sum could be left to her son. The check could not. The lump sum could be spent on a surprise, like a new roof. The check could not. But the lump sum also meant she had to watch her money every month, and she told me that gave her a tight stomach. She also priced an annuity from an insurance company for a comparable sum. The quote she got was close to the plan's own offer, which told her the plan's price was in the fair range.

Denise picked the monthly check and kept a separate savings account for surprises. That was her choice, made with her own numbers. Yours might land somewhere else, and that is fine.

Where it goes wrong

I have seen good people trip over the same few stones. The first is looking only at the big number. A lump sum of 240,000 dollars sounds like a lot of money. But it has to last a lifetime, and no one knows how long that is. Big is not the same as enough.

The second stone is forgetting the spouse. If you take a single life payment and you die first, your husband or wife may be left with nothing from the plan. Talk it through together before you sign. The survivor option costs you a smaller check, but it buys real peace of mind.

The third is the tax bill. Taking the lump sum as cash instead of rolling it over can trigger a large tax bill in one year. If you are under a certain age, an early withdrawal penalty may apply too. See the IRS pages on early distributions for the current rules. A direct rollover is often the cleaner path unless you have a clear reason to pick another.

The fourth is trusting the plan without asking questions. Plans are run by real people who make mistakes. Get every figure in writing. Ask what interest rate they used. Ask what happens if the employer is bought or goes under.

The last is going it alone. A fee only financial planner, one who charges a flat fee and does not earn commissions, can look over your numbers. So can a tax preparer. The Department of Labor's Employee Benefits Security Administration also has free guides on pension choices. Ask for help. It is no sign of weakness.

Questions to answer before you leave this page

Do you know how much your monthly check would be, and how much the lump sum is, in writing? Have you asked the plan what discount rate it used to figure the lump sum? Would your spouse or anyone else depend on this money after you are gone? Do you have other steady income, like Social Security, that already covers your basic bills? How would you feel if the lump sum lost value in a bad year? Do you want to leave something behind to your family, and how much does that matter to you? Have you priced a comparable annuity from an insurance company to see how the plan's offer stacks up? Have you talked with a tax professional about what a rollover would do to your taxes? And when you picture yourself at eighty five, which choice lets you sleep better?