Pension versus Lump Sum

Your company would prefer that you take the lump sum because it reduces their financial, administrative, and legal obligations. Your financial advisor wants you to take the lump sum because most are paid a fee based on the percentage of assets they manage. What should you do?

There is no one-size-fits-all answer. You need to evaluate your unique situation with a variety of assumptions, including your projected life expectancy and benefit amounts. Here are a couple things to account for in your analysis.

The sequence of returns matters.

The order in which you earn returns makes a big difference. Let’s say you have 2 portfolios that each begin with $100,000, distribute $5,000 per year, and earn 7% per year on average. At the end of 25 years, they are not going to have the same dollar amount. In one slide that I show clients, Portfolio A will run out of money in 20 years and Portfolio B will have $240K at the end of year 25.

How can this be possible? Portfolio A suffered from a worse initial decade in retirement with more negative returns. The next 2 decades made up for it, but it doesn’t matter. The damage was done.

In the example above, if you are calculating a lump sum versus pension analysis based on a consistent 7% rate of return every single year (as many do in DIY excel retirement plans), the lump sum may come out ahead because you are not taking into account the fact that the portfolio’s returns will be variable.

You should also be conducting stress tests. For example, my software allows me to conduct a Monte Carlo analysis, which runs 1,000 trials with variable portfolio returns based on the standard deviation (risk) of the selected portfolio (60/40, 50/50, etc). The result is a “probability of success” equal to the number of successful trials divided by 1,000. When I do the stress tests, many times the pension comes out ahead.

When NOT to elect a pension

While it is important to crunch the numbers when deciding on a pension versus a lump sum, the analysis does not end there. Your pension benefit is a promise to pay a certain amount in retirement. While it sounds simple, that guarantee is only as good as the company’s ability to pay. In fact, I became a financial planner after reading about United Airlines filing for bankruptcy in the early 2000s. They defaulted on their employee pension plans and, overnight, employees saw their pensions disappear or be greatly reduced, some by 50%. I personally know a pilot that had to go back to work in his 60s because his pension was not what it was promised to be. I realized at that moment that retiring, and staying retired, was apparently harder than it looked.

That moment in history led to a variety of changes including the Pension Protection Act of 2006 and updates to the PBGC, which insures private-sector pension plans. While that is assuring, it is more assuring to see how well-funded your pension plan is each year. Luckily, there is a way to check.

How to determine if your pension is in good financial shape

You should be receiving an annual funding notice each year from your plan administrator. If you have not received it, you can request one. You can also search for the pension plan’s Form 5500. This is a form they will file each year with the federal government to show how funded their pension plan is. For example, in 2019, CalPERS (California Public Employees' Retirement System) was 70% funded. Pension plans in New Jersey were only 36% funded. That is terrible and many state pension plans are unfortunately, in trouble, only to be exacerbated by the current financial recession. If you are curious, here is a map to see how well funded state pension plans are across the U.S.

Private pension plans are faring better and most that I check are fully funded - around 100%. If your plan is much lower than that, you may want to consider the lump sum option to reduce the risk of a pension default.

Federal pensions are considered safe because they are backed by the full faith and credit of the U.S. government. It would take an act of Congress to change a federal employee's retirement benefit.

Understand your pension plan’s options

Do the analysis to determine if you should choose the pension over a lump sum. If you decide to elect the pension, confirm that it is fully funded. If it is not, you may want to choose the lump sum to not have to worry about your benefits being reduced at some point in the future due to a pension plan’s mismanagement. Meet with a virtual, fee-only financial advisor if you want an objective, third-party’s opinion.

Linda Rogers, CFP®, EA, MSBA is the owner and founder of Planning Within Reach, LLC (PWR). Originally from New Jersey, Linda services clients nationwide and is based in San Diego. She leads the design of PWR's investment portfolios which utilize broad, low-cost investments that integrate environmentally, socially, and governance (ESG) factors.

Planning Within Reach, LLC (PWR) is a virtual fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning, ongoing impact-focused investment management and tax preparation services. PWR is a woman-owned firm that specializes in busy professionals and impact investors. Planning Within Reach, LLC and their advisors do not receive commissions and do not hold any insurance licenses or brokerage relationships.