Why would an individual opt to receive a lump sum payment? Some experts offer their insights.
The entire matter, MetLife says in its recent study, “Paycheck or Pot of Gold Study: Making Workplace Retirement Savings Last,” is a relatively new phenomenon. The study points out that defined benefit plans — long the predominant retirement plan — offered a steady form of income. However, the advent of DC plans changed that, as well as the rise of DB plan lump sum distributions in the 1990s.
With the prevalence of defined contribution plans, most of whose holders receive their funds in a single payment that they must then manage, how well one understands — and manages — those windfalls is critically important.
Michael Kitces notes in his “Nerd’s Eye View” blog, “Selecting the lump sum gives the retiree the potential to invest, earn more growth, and generate even greater retirement cash flows… and if something happens to the retiree, any unused account balance that remains will be available to a surviving spouse or heirs,” He continues, “Retirees who are eligible for a pension are often offered the choice of whether to actually take the pension payments for life, or instead to receive a lump sum dollar amount for the “equivalent” value of the pension — with the idea that the retiree could then take the money (rolling it over to an IRA), invest it, and generate his/her own cash flows by taking systematic withdrawals throughout retirement.”
Aaron Pottichen, President, Retirement Services at CLS Partners, says, “My general advice is that if you are younger the lump-sum is a better option because you have time on your side and can control your investment expenses. Those two items may make your lump-sum worth substantially more later on in life than if you were to take the annuity now.” The Pension Rights Center argues that a lump sum payment may make sense if one already has “a substantial nest egg” or some other secure source of adequate income; for instance, a spouse’s pension.
Kitces argues that while there are several factors that affect the decision of whether or not to receive a lump sum, “ultimately the trade-off can be boiled down to calculating the internal rate of return of the promised pension cash flows, which reveals the ‘hurdle rate’ of return that a lump sum portfolio would have to earn to generate to reproduce those same payments over the same time horizon.”
Kitces adds that since life expectancy varies by individual, and the size of a lump sum as opposed to a pension payments will as well, the decision of which to take can vary from one person to another.” In some cases, choosing a lump sum will clearly be best, e.g., when life expectancy is short or the hurdle rate is especially low,” says Kitces.
One also can consider earning potential, Kitces suggests: “If you think you can outearn the internal rate of return (and are ready to bear the risk that you do not), a lump sum should be more appealing than the pension option.”
Health is another consideration, Kitces suggests, saying, “it is also typically prudent to minimize pension payments to an unhealthy person to the extent possible — so if the non-pensioner spouse is healthy, you might lean towards a reduced survivor payout or simply go straight life on the primary pensioner. Alternatively, if the primary pensioner is unhealthy but the spouse is healthy, maximize the survivor option to the extent possible (or again, consider a lump sum). The Pension Rights Center also says that a lump sum payment may make sense if one is in poor health or doesn’t expect to live long.
But be careful, says the Pension Rights Center: “While the idea of suddenly having a large sum of money is tempting, this is a decision that you will have to live with for the rest of your life. Anyone who accepts the lump-sum offer will lose the benefits of a lifetime income and will be responsible for taking care of their own investments and making sure the money lasts through retirement.” Pottichen, too, strikes a note of caution, saying, “The downside of this option is that you will have to wrestle with the difficulties of managing your behavior, which can become really difficult when the markets take a dive or act irrationally.”
The entire matter, MetLife says in its recent study, “Paycheck or Pot of Gold Study: Making Workplace Retirement Savings Last,” is a relatively new phenomenon. The study points out that defined benefit plans — long the predominant retirement plan — offered a steady form of income. However, the advent of DC plans changed that, as well as the rise of DB plan lump sum distributions in the 1990s.
With the prevalence of defined contribution plans, most of whose holders receive their funds in a single payment that they must then manage, how well one understands — and manages — those windfalls is critically important.
Michael Kitces notes in his “Nerd’s Eye View” blog, “Selecting the lump sum gives the retiree the potential to invest, earn more growth, and generate even greater retirement cash flows… and if something happens to the retiree, any unused account balance that remains will be available to a surviving spouse or heirs,” He continues, “Retirees who are eligible for a pension are often offered the choice of whether to actually take the pension payments for life, or instead to receive a lump sum dollar amount for the “equivalent” value of the pension — with the idea that the retiree could then take the money (rolling it over to an IRA), invest it, and generate his/her own cash flows by taking systematic withdrawals throughout retirement.”
Aaron Pottichen, President, Retirement Services at CLS Partners, says, “My general advice is that if you are younger the lump-sum is a better option because you have time on your side and can control your investment expenses. Those two items may make your lump-sum worth substantially more later on in life than if you were to take the annuity now.” The Pension Rights Center argues that a lump sum payment may make sense if one already has “a substantial nest egg” or some other secure source of adequate income; for instance, a spouse’s pension.
Kitces argues that while there are several factors that affect the decision of whether or not to receive a lump sum, “ultimately the trade-off can be boiled down to calculating the internal rate of return of the promised pension cash flows, which reveals the ‘hurdle rate’ of return that a lump sum portfolio would have to earn to generate to reproduce those same payments over the same time horizon.”
Kitces adds that since life expectancy varies by individual, and the size of a lump sum as opposed to a pension payments will as well, the decision of which to take can vary from one person to another.” In some cases, choosing a lump sum will clearly be best, e.g., when life expectancy is short or the hurdle rate is especially low,” says Kitces.
One also can consider earning potential, Kitces suggests: “If you think you can outearn the internal rate of return (and are ready to bear the risk that you do not), a lump sum should be more appealing than the pension option.”
Health is another consideration, Kitces suggests, saying, “it is also typically prudent to minimize pension payments to an unhealthy person to the extent possible — so if the non-pensioner spouse is healthy, you might lean towards a reduced survivor payout or simply go straight life on the primary pensioner. Alternatively, if the primary pensioner is unhealthy but the spouse is healthy, maximize the survivor option to the extent possible (or again, consider a lump sum). The Pension Rights Center also says that a lump sum payment may make sense if one is in poor health or doesn’t expect to live long.
But be careful, says the Pension Rights Center: “While the idea of suddenly having a large sum of money is tempting, this is a decision that you will have to live with for the rest of your life. Anyone who accepts the lump-sum offer will lose the benefits of a lifetime income and will be responsible for taking care of their own investments and making sure the money lasts through retirement.” Pottichen, too, strikes a note of caution, saying, “The downside of this option is that you will have to wrestle with the difficulties of managing your behavior, which can become really difficult when the markets take a dive or act irrationally.”
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