As companies move away from defined benefit pension plans to defined contribution plans, many active and retired employees are faced with decisions to take a lump sum payment today or hold out for the promised periodic pension payment at some defined date in the future. If you are faced with this choice, how can you make an educated decision?
Do the math. When you are offered a lump sum payment, run the analysis and compare the variables. For example, if you are 50 years old and are offered a lump sum offer of $300,000 today compared to a monthly pension of $1,000 when you turn 65, evaluate the present as well as future values of each option to see how the numbers stack up. Make sure you factor in estimates for inflation, your time horizon (number of years in retirement), as well as a hypothetical rate of return on your investment – which can vary quite a bit depending on the level of risk you are willing to take.
Examine the tax consequences. If you take a lump sum payment, consider rolling over assets into a qualified investment such as an Individual Retirement Account (IRA) to postpone taxes and potentially avoid penalties. If you do not roll these assets into a qualified investment you will be subject to regular federal income taxes on the entire amount, plus a penalty depending on your age. Tax laws and regulations are always subject to change, so know the rules and how they impact your particular situation.
The dollars do not tell you everything. There are many other variables to look at when making this decision, such as: Do you have other sources of retirement income or will this be your primary source? Is there a cash flow need that cannot be met otherwise and will result in taking out a loan with interest?
Consider the risks. If you take a lump sum and invest your proceeds (so inflation doesn’t erode your account value over time), make sure you factor in all risks, such as general market and specific investment-related risks. If you do not take the lump sum, consider the risks that the company will freeze or alter their pension benefits.
Ultimately, there is no perfect answer to this question. To adequately decide, you should consider the present and future values of your pension options and applicable tax consequences, as well as your age and life expectancy, risk tolerance, and retirement income needs and goals.
Kevin Dombrowski is director of client development with MainLine Private Wealth.