Not everybody is lucky enough to have a monthly pension payment waiting for them in retirement. But those who do have a pension might have a very important decision to make. Should they take a lump sum payout or should they stick with the monthly payments?
The 6% Payout Test
There is an interesting quick test that one can run to quickly estimate how much the pension lump sum payout needs to be in order to replicate the monthly pension payments. To figure out if your pension passes the 6% test, multiply the monthly pension payment by 12 then divide by the lump sum payout offer. Then multiply this number by 100.
Here is an example of using this test. You are offered $2,000 in monthly pension payments starting at age 62. The other option is a lump sum payout at age 62 of $300,000. The calculation for this test is: ($2,000 * 12)/$300,000 = 8%. This tells us that you would need to earn approximately 8% per year on the lump sum payout in order to mimic the monthly pension payment of $2,000. This is no easy task and would require most (if not all) of the pension payout to be invested in stocks.
This test also does not take into account the pension survivor benefits. If you pass away before your spouse, do the pension payments continue to go to your spouse? If so, what percent will continue? The 6% test assumes that 100% of the benefits will continue because it is running the test vs. the lump sum payout, which your spouse would get to keep if you passed away first.
The Better Way to Determine if a Lump Sum Payout Makes Sense
A decision this important should be run using accurate retirement planning software such as WealthTrace, which considers all of the variables you need to determine if you should take the lump sum or the monthly payments for a pension.
Besides the survivor benefits option already discussed, there are other variables that only a comprehensive retirement planning application can take into account. Your taxes can change every year in retirement based on Required Minimum Distributions (RMDs), withdrawals from retirement accounts, life expectancy, and many other factors. If you can’t accurately project all of these variables then you might be making an important decision based on bad information.
Inflation can have a Major Impact on Pension Payments
Most pensions are not tied to any type of inflation rate. Some have a fixed growth rate and other never grow at all. With inflation still raging, the real dollar value of most pensions is declining.
Let’s take a look at an example. John has a pension that pays him $3,000 per month. It does not grow at all over time. Let’s say the rate of inflation is 3% per year for the next 20 years. In 20 years that $3,000 monthly pension can no longer buy what it used to. Due to the compounding of inflation over time, that $3,000 can only purchase $1,700 worth of the same goods and services! In other words, the value of the pension has been cut nearly in half over 20 years. If the inflation rate is 4% over that same time period, the real value of the pension falls to only $1,350 per month.
Inflation is an extremely important variable when deciding whether or not a lump sum payout is better than monthly payments for life. If you think inflation will remain relatively high for a long period of time, a lump sum payout will likely make more sense because you can take the money and invest it in vehicles that (hopefully) will beat inflation over the long-run and preserve the pension’s purchasing power.
Life Expectancy
There is a break-even life expectancy when it comes to the decision of taking the lump sum payout vs. monthly payments for life. The longer you live, the more beneficial the lifetime payments are. This is very similar to the decision when it comes to delaying when to take Social Security benefits.
When people delay taking Social Security benefits until age 70, the payments increase but they miss out on several years of payments. Because of this, they normally have to live until at least age 78 for it to make sense to delay.
Other Factors in This Decision
If your pension isn’t big enough to pay for all of your expenses in retirement, you might have to withdraw from your retirement 401(k) or IRA accounts. These withdrawals will be taxed at your federal and state income tax rates. But if you take the pension in a lump sum, you will have more money at your disposal to pay for expenses and you can let your retirement accounts grow tax-deferred for a longer period of time.
The projected rate of return on the lump sum payout is also a big factor in this decision. As mention previously, if you can find investments that beat inflation over the long-run, this greatly increases the benefits of the lump sum payout. But if you plan on just putting the money into a low interest rate savings account, this greatly decreases the benefits of the lump sum payout.
If your pension is through a private company, you have the risk that the company goes bankrupt in the future and will not pay out its pension obligations. Most private pensions are insured by the federal Pension Benefit Guarantee Corporation (PBGC), but only up to a certain dollar amount. For those with large pension payments, they might not get their full payments if their previous employer goes bankrupt.
An Important Decision That Requires Serious Thought
Don’t guess when it comes to the decision on whether or not to take a lump sum pension payout. Spreadsheets and free, simple calculators are also not good enough. You have to take into account many variables when deciding how to take your pension. If you can’t create your own retirement plan that helps you with this, hire a financial planner. In the long-run the correct decision can mean thousands of extra dollars in your pocket.
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Image and article originally from www.savingadvice.com. Read the original article here.