Within the past few weeks, I have had more than a few people ask about a prior employer offering a lump sum payout vs. leaving it in the plan and taking a monthly payout at a later date.I’m not sure if companies are making this “the lump sum season” intentionally or not, but there has been a major influx of conversations about this topic. I’m figuring for every person that is asking, there are probably many more sitting there silently and trying to make the decision on their own. That sounds like a great reason to write a blog post. Here is the process that I walk through with a person to help them evaluate their options when they have a lump sum opportunity.
The first thing we do is look at the choices provided by the former employer. Most of the time the choices are: A – Do nothing and allow it to become a monthly pension in the future. B – Roll the lump sum into a rollover IRA. C – Roll the lump sum into a current employer’s 401(k) or 403(b). D – Take a check and pay the taxes, lots of taxes. The decision that is usually ruled out quickly is taking the check and paying taxes. For those under 59 ½ years old, the total tax bite is usually in the 40-50% range when factoring in federal (income + 10% penalty) and state taxes. Only in cases of emergency (medical or to prevent eviction or foreclosure) is this option viable or desirable.
So the question really comes down to rolling it into a 401(k) or rollover IRA (your investment preferences can help you choose which is best for you) vs. taking the monthly income later. There are quantitative and qualitative factors to consider. The biggest qualitative question: Do you prefer to have a lump sum that you manage or do you prefer to have the security of a monthly check?
That question then can launch into the number crunching part. When crunching the numbers, I like to do a quick little analysis to see what kind of payout rate the pension would have based on various investment scenarios. For the sake of illustration, I’ll keep the numbers consistent and simple. Let’s say you have the option of either a $10,000 lump sum or $100/month at age 65 (age 50 now so 15 years of growth is possible on the $10,000).
- At a 3% growth rate (you take the $10,000 and invest conservatively), the $10k becomes $15,580. $100/month or $1,200/year equates to a payout rate of 7.7% (1,200/15,580)
- At a 5% growth rate, the payout rate is 5.77%
- At an 8% growth rate, the payout rate is 3.78%.
While these numbers are purely hypothetical, they are telling. In the world of financial planning, a rule of thumb is that there is a “safe withdrawal rate” assumption of 4%, which means if you are withdrawing 4% (increased for inflation annually after the first year) or less of your nest egg annually, you should not outlive your funds in a normal retirement period. Only the 8% growth rate on the $10,000 lump sum provides a payout rate below 4%.
How confident would you be that you would be able to earn 8% annually or more in your investment portfolio in the next 15 years? And remember that if you choose the monthly income, you won’t have the lump sum available in the event of an emergency so you would need to have enough set aside in cash to handle things like needing a new roof, or a very high medical expense year, etc. In most of the cases I have seen lately, the pension payout is in the 7-8% payout rate, which suggests that you would need VERY strong investment performance between now and age 65 to make taking the lump sum a more attractive option.
But that’s if your prior employer has a well funded pension plan! If the employer is experiencing financial hardship and you are concerned about their strength, which would potentially impact their ability to pay you 15 years from now, maybe taking the lump sum now looks more attractive. The employer’s fiscal strength is another one of those quantitative factors that goes into making this decision.
Along with that, remember that most pensions don’t increase annually for inflation while your investments can. If your pension offers a COLA (cost of living increase), make sure you consider that option if you expect to have longevity. While you may have to take a smaller payout in the early years, with a COLA you may be far better off in the long run – typically if you live past your mid-80’s.
This decision is becoming more and more common as employers offer lump sum pension payout options and freeze or terminate their pensions. It’s a fairly complex decision as well. But if you use this as a framework for thinking through your decision and consult with a financial professional about other ways to view it, you stand a very good chance of making a decision that works very well for you and your family.