Pensions are a dying breed of retirement vehicle as more and more companies and institutions move away from an employer-owned retirement fund to an employee-owned 401k or similar. For those at or nearing retirement age, at some point you will have The Meeting with the appropriate HR / Retirement Specialist in your company to determine What To Do with your pension.
Every situation is a little different, but the basic question YOU need to answer is: do I take a monthly payout from an annuity, or do I take a lump sum distribution? I can give you two scenarios; in the first, a gentleman asked me about his pension options and I asked him how much the lump sum would be, and he said that was not an option offered to him by his HR advisor. In fact by law it is an option if you have not already started taking payments. We lost contact but I believe he simply signed up for monthly payments. Which is probably unfortunate for him and his family.
As another simple example, we recently spoke with someone who was eligible for their pension of $750 a month or they could take a lump sum, one-time distribution of $170,000. The $750 per month is for the rest of her life, starting at age 65. The pension holder uses actuarial tables (same as used by insurance companies) to determine the present value of that payment, which is where they get the $170,000 figure. And in this case it’s based on less than a 6% rate of return.
Here’s the problem with taking monthly payments; when you die, the payments die too. (Note that if your pension provides a survivor benefit, the main benefit is even less) In the second scenario, if the woman invests the $170,000 in good growth stock mutual funds in an IRA, she can pull off 5% – 6% per year to equal the $750 per month – or more – that the annuitized pension payments were providing. The mutual funds will likely return much higher than 6% per year on average, so the “goose laying the golden egg” will never deplete. In fact it will probably grow in value. So that when she dies, she will still have north of the $170,000 originally invested to leave as an inheritance.
There is of course a risk to taking the lump sum. If the stock market dives in half, the value of that $170,000 would drop to $85,000 and if you continue to pull off $750 a month during THAT year, you will eat up a higher percentage of the balance. But, given that the S&P 500 has returned higher than that on average, given those two sets of numbers, I’m quite confident that the lump sum beats out the annuity payments.
The formula to figure this out is: (monthly payment) * 12 / (lump sum payout). In our example, it’s 750 * 12 / 170,000 which equals .0529 or a 5.29% rate of return. That’s how much they are paying on “your” pension. Using a good investment pro you can pretty easily find mutual funds that average double that for the last 20-30 years. If it were me, if the rate of return is less than 7% I’m taking the lump sum because I think I can do better than that by rolling the lump sum over in a set of good mutual funds inside of my IRA. If the rate of return is 8% or higher, you might make a case for the monthly payments if the pension is your only source of income and if you do not have the need to leave an inheritance.
Not every situation will be this simple, and you should talk to (at least) two different people: your HR / pension rep, and a good investment pro. Realize they both have an agenda – the pension rep wants you to take the monthly annuity because it’s better for the pension plan / company asset, and the investment pro can only make a commission if you roll over a lump sum to an IRA (or you can DIY if you are savy in picking mutual funds). So, interview both and choose wisely.
But that’s my opinion. What’s yours?