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Lump Sum vs. Lifetime Monthly Payments: What Should I Do With My Pension?

Do you know what pensions and movie rental stores have in common? They've both been replaced by the “new way” of doing things. Netflix took down Blockbuster, and the 401(k) put pension plans on the endangered species list.

Back in the day, pensions allowed folks to receive a lifetime monthly payment for the rest of their lives. It was a pretty sweet deal! Now it looks like pensions will be joining those movie rental chains in the trash bin of history very soon. The times, they are a-changin’.

With the costs of running a pension going way, way up, the few companies and industries that still offer pension plans are looking for a way out of their pension obligations. So what are they doing? They’re giving employees a choice: Take a lump-sum payment now or hang on to their pension and receive a monthly payment for the rest of their lives when they retire later.

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Maybe that’s the choice you are facing right now and you’re not sure what to do. We get it! It’s a big decision, and you want to make the right call. Don’t worry, we’re going to walk through your options together so that you can make the best choice for your retirement future.

What Is the Lifetime Monthly Payment?

If you choose your pension plan’s monthly lifetime payment option, that means you’ll get a benefit check every month for the rest of your life after you retire (kind of like an annuity). Traditionally, this is how pension plans—also called defined-benefit plans—usually work.

The monthly benefit will always be the same amount each time. So if your monthly lifetime payment is $1,000, then you’ll get $1,000 each month like clockwork. And yes, you do need to pay taxes on your pension payments.

How is that amount calculated? In most cases, pension plans will use a formula that looks at three things:

  • Years of service. If you worked at the company for 25 years, that’s the number that will be used in the formula. Pretty straightforward! The longer you’ve worked at your company, the larger your monthly benefit will be.
  • Your final average salary. Depending on what state you’re in, this number might look a little different. But in most cases, companies will use your final three to five years of salary in the formula. Some places will take the average of the three to five years of your highest salary and use that number instead. It just depends!
  • A benefit multiplier. This is just a percentage (usually between 1–2%) that pension plans use to figure out the size of your benefit.

So what’s the actual formula? Here it is:

(Years of Service) x (Your Final Average Salary) x (Benefit Multiplier)

= Annual Lifetime Benefit

So let’s go through an example so you can see how this plays out in real life. Meet Mr. Simmons. He’s a teacher who just turned 65 years old and he’s worked at the same school for 30 years. Now he’s ready to call it quits and move to Florida like he’s always dreamed about. Sounds nice!

He’s planning on taking the monthly lifetime benefit, but now he’s wondering how much money he’ll receive from his pension each month. Mr. Simmons’ average final salary over the last three years was $50,000 and the pension plan uses a 2% benefit multiplier to figure out what someone’s annual lifetime benefit will be. So now all he has to do is plug in the numbers:

STEP 1: (30 years of service) x ($50,000 final average salary) = $1,500,000

STEP 2: $1,500,000 x (2% benefit multiplier) = $30,000 lifetime annual benefit

STEP 3: $30,000 lifetime annual benefit / 12 months = $2,500 monthly benefit

That means Mr. Simmons will be getting $30,000 each year from his pension. Divide that annual benefit by 12 months and Mr. Simmons figures out he will receive $2,500 each month for the rest of his life from his pension. Happy retirement, Mr. Simmons!

What are the advantages and disadvantages of a lifetime monthly payment?

So the biggest advantage of the lifetime monthly benefit is pretty obvious: You’re going to have a steady income stream for the rest of your life. Some folks hear that and think “financial security.” And there is something reassuring about that.

You’re also not responsible for investing the money or any of the costs of managing your investments—that’s on your employer or whatever company is running your pension plan. But there’s a flip side to that: Investment returns for pension funds usually underperform the stock market. Just look at state pension plans, which have an average rate of return of between 7–8% while the stock market averages between 10–12%.1,2

Many pensions also don’t adjust for inflation, which means as the years go by and things get more expensive, your monthly checks won’t be able to buy what they used to.

But that’s not all. There’s another problem: Pension plans are not always a sure thing—not anymore. First off, many pension plans are either underfunded or in danger of becoming underfunded. According to the U.S. Department of Labor, there are hundreds of pension plans across the country that are in danger of being unable to meet their pension obligations.3

And then there are workers and retirees wondering whether or not they’ll be getting their pensions at all because their companies are going bankrupt or facing financial problems. Sears and General Electric have made national headlines over their struggles to meet their end of the deal . . . and it’s not pretty.4,5

Back in the 1970s, the government made a safety net for workers and retirees by creating the Pension Benefit Guaranty Corporation (PBGC). This federal corporation takes over pension plans when the company that offers the pension plan (or plan’s sponsor) can no longer provide the benefits they promised to their employees and retirees. But even the PBGC is facing its own financial problems. Currently, they are more than $48 billion in debt . . . and it’s expected to get even worse over the next several years.6

And here’s probably our least favorite thing about pensions: They die with you. Sure, some pension plans offer spousal survivor benefits so your spouse will at least receive some money, but it’s usually just a portion of what your monthly benefit was. And what if you’re not married but have kids? Unfortunately, your children probably won’t get anything—your pension would simply go up in smoke.  

All this is not to startle you, just to make sure you keep your eyes open if part of your retirement is wrapped up in a pension. What’s the big takeaway from all this? You shouldn’t be depending on a company or the government for your financial security in retirement. Securing your retirement future is your job! So let’s talk about the lump-sum option.

What Is a Lump-Sum Payment?

The lump-sum payment is when you receive one large cash payment from your pension plan instead of receiving your pension in monthly installments. Think of it as a “buyout”—your employer is trying to get out from its future pension obligations by giving you one big payment now.

Like the lifetime monthly benefit, your lump-sum offer is calculated based on a set of factors. In this case, your current age, your salary, how long you’re expected to live and interest rates set by the IRS are a few of the numbers that employers use to figure out what to offer you in a lump sum.7 Mistakes can happen, so make sure you take a real close look at your pension statement and verify that all the information is correct before you accept any lump-sum offer given to you!

Let’s go back to Mr. Simmons and rewind the clock. He’s 45 years old now, still a couple of decades away from retirement, and his employer approaches him with a lump-sum option offer of $100,000. That’s a pretty big chunk of change!

He can take the money and run, but he would be giving up his future lifetime monthly benefit in the process. Is it worth it?

What are the advantages and disadvantages of a lump-sum payment?

Now, you basically have two options when you receive a lump-sum payment: You can cash out that money or you can roll the money over into a traditional IRA.

If you cash out the money, that will count as taxable income and you’ll most likely have to pay income taxes on that money right away. Depending on the size of the lump sum, that could add thousands of dollars to your tax bill.

Instead, we suggest rolling over that lump-sum payment into a traditional IRA so that your money can stay invested and keep on growing. Why not a Roth IRA? Because the money from a lump sum would count as taxable income, and rolling the money into a Roth could knock you into a higher tax bracket and leave you with a pretty hefty tax bill depending on the size of your lump sum.

Then, you could work with a financial advisor to help you pick good growth stock mutual funds to invest that money in. But remember, with a traditional IRA you will need to pay taxes when you make withdrawals in retirement later. Just keep that in mind!

The great thing about the lump-sum payment is that it gives you control of your money. First of all, you can invest the lump sum however you want to and potentially earn a higher rate of return than the way it was being invested inside the pension. And second, whatever is left of the lump sum once you die can be left behind for your spouse and your kids.

Are there any disadvantages to the lump sum? Well, taking a lump sum is a huge responsibility because there is less margin for error. A few bad decisions—like spending it all on a yacht or investing it in a single stock—and your lump sum could disappear or not grow enough to help you live the way you want to in retirement.

That’s why we always recommend working with a financial advisor to make the most of your lump sum. Not only can a qualified pro help you steer clear of decisions that could derail your financial future, but they can also help you pick and choose investments that will move you closer to your retirement goals.

Lifetime Monthly Payment vs. Lump Sum: Which One Is Better?

In most cases, the lump-sum option is clearly the way to go. You want to have control over how your money is invested and what happens to it once you’re gone. If that’s the case, then the lump-sum option is your best bet.

Let’s look at Mr. Simmons situation one last time. Let’s say he decided to wait and take the monthly benefit payments once he retires at age 65. If he lives for another 20 years, receiving $2,500 every single month during his retirement, he’d end up receiving a total of $600,000 from his pension plan.

But what if he took the $100,000 early lump-sum buyout offer at age 45? And what if he rolled that lump sum into a traditional IRA and invested in good growth stock mutual funds? Even if he didn’t put another penny into the IRA, he could have close to $900,000 by the time he retires at age 65—that’s about $300,000 more than his pension payments would be worth.

And just for kicks: If Mr. Simmons just invested $200 every month into the IRA during those 20 years, it’s very possible that he would wind up with more than $1 million in his nest egg at retirement. That’s right: Mr. Simmons could become a millionaire if he plays his cards right—and so could you!

And if he passes away, whatever money is left can go to his wife and kids. If he stuck with his pension, his wife might be able to receive some form of monthly benefit from the pension . . . but then it dies with her.

The choice is pretty clear, don’t you think?

Work With a Financial Advisor

The only person responsible for securing your family’s retirement future is you. You have to make decisions that are going to help make the most of your investments so that you won’t have to worry about running out of money in retirement.

If you don’t have a financial advisor to help you invest for retirement, you need one! That’s why the SmartVestor program exists: to connect you with a financial advisor or investment professional who can help you come up with a plan to reach your retirement goals

Find your SmartVestor Pro today!  

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.

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