Pension or Lump Sum Buyout: Questions to Ask Before Making the Decision

Deciding whether to keep your pension or take a lump sum buyout can shape your financial security in retirement.

As many corporations and state and local governments shift away from pension offerings as they struggle under tight budgets, they are offering employees the options of taking a buyout. While a major cash infusion is tempting, financial planners said the decision should be thoroughly thought out taking into consideration your age, family, health, lifestyle and budget.

Since life expectancy is 78.5 years, according to the CDC, people retiring at 65 need to plan for funding at least the next 13 years. Knowing your cash flow needs are key—if you outlive your money, you may have to rely on family or limit your lifestyle in your later years, says Jeff Rand, regional sales manager at Merrill Edge. “Look at your life expectancy and lifestyle to figure out how much you need saved.”

Before making a decision, experts suggest asking the following questions about your plan and retirement goals.

Why is the company making this offer?

Pension plans have failed in the past and experts suggest researching to determine whether yours is appropriately funded. “It may be that a significant underfunding may bring on future problems with the pension plan and impact retirement income if the firm has problems funding the pension plan,” says San Diego-based Certified Public Accountant Leonard Wright. According to the Pension Protection Act, companies are required to disclose their pension plan’s funded percentage.

“If a company terminates a plan, that’s where [the Pension Benefit Guaranty Corporation] comes in,” says Joseph Montanaro, certified financial planner at USAA. PBGC insures most private pension plans and lists these on www.pbgc.gov. Congress sets the limits annually, with about $65,000 covered for 65-year-olds. “Someone may not want to take the pension because the company’s struggling, but that may not be a huge factor because of PBGC,” says Montanaro.

If your pension’s much higher than PBGC’s limits, Wright suggests considering your options.

How does this money fit into your retirement plan?

Having fixed expenses covered by fixed income, such as pensions, annuities and Social Security benefits, is an integral part of a retirement plan, says Montanaro. He recommends creating a budget that shows monthly expenses for necessities like housing, food and health care. Whether your monthly income covers this amount is key to this decision.

Consider how the pension works for your family circumstances. “You can take an income stream on your life expectancy or you can get a portion while you and your spouse are alive,” says Michael Goodman, certified public accountant and president at Wealthstream Advisors. To insure two lives, you’ll get some discount based on your life expectancy but the surviving spouse will continue to receive income.

To maximize the pension, Goodman suggests taking the entire pension and buying life insurance with a portion of the monthly payments. If one spouse outlives the other, he or she could cancel the insurance policy and take the cash or leave the money to the next generation. If the couple lives longer than expected, they can cancel the policy and take the cash at any time. “In effect, you bought your own plan,” says Goodman.

What to do with a lump sum?

“If you’re at an age of substance before you want to retire and /or you have plenty of money in non-retirement accounts that you can live on and are comfortable with the markets, take the lump sum,” says Goodman. Other assets should be in a non-retirement account to minimize taxes.

Rolling this money into an IRA will preserve the tax-deferred status, says certified public accountant David Bendix. “If you don’t roll it over, you’ll get taxed at that income rate.” Whether you buy an annuity or invest the money in the market, make these investments in the IRA.

“If the lump sum is a big number, you might want to put half in an account and get an immediate annuity with the other half,” says Goodman. Having annuities as a part of your retirement plan can increase the likelihood of success in meeting your goals.

Annuities are safe investments, says Jean Setzfand, vice president for Financial Security at AARP. “Neither the stock market, a housing bubble, an interest-rate-fixing scandal, nor a presidential election will impact your annuity paycheck. An annuity provides peace of mind when you need it most.” Private insures that offer annuities are required to pay into state guaranty associations that pay claims against bankrupt insurers.

Experts warn about the risks of investing a lump sum distribution in the equity markets. A typical market cycle lasts from five to seven years, with below average returns for at least two years, says Rand. If you’re able to earn 7% to 10% per year on your portfolio, it’s never 7% to 10% every year—you may have negative returns one year and make 15% the next.

“Evaluate your skills from an investing standpoint and your emotional tolerance to spend the money,” says Montanaro. A stream of income is a more conservative option since it’s guaranteed for life and isn’t a finite amount of money that you can spend. Consider your goals and health issues also since these may dictate whether you need more money now.

How are you protected against inflation?

“Do an acid test,” says Montanaro. Talk to an insurance company and figure out the type of annuity you could buy and how much it would pay each month. “If there’s a discrepancy, consider taking the option that would pay you more but don’t forget about important factors like cost-of-living adjustments.”

Whatever you choose, the pension you receive at 60 years old will be a lot less than what you need when you’re 80. Some pensions do offer cost of living adjustments, says Goodman.

For those that don’t, Rand suggests planning for inflation. “Don’t spend all the money coming in—spend 75% of it and invest the other 25%,” he advises. Give yourself a 3% raise every year with the money you’ve set aside.

There are different ways to invest this money but if you choose the stock market, Rand recommends a mix of small-cap, large-cap, mid-cap and international stocks. Buying investments regularly by dollar-cost averaging will help weather market fluctuations. “You want risk at appropriate levels,” says Rand.

Although annuities may result in lower monthly payments than your pension, there is an upside. “Many insurance companies offer inflation protection riders that will give you cost-of-living adjustments over time,” says Setzfand.