Managing your financial life is not just about money.

Lump Sum (Investment) vs. Pension (Insurance)

Most workers have a voluntary, contributory retirement plan option available to them at their place of work. The worker contributes money from his/her paycheck, the employer may also contribute funds to this account via some kind of match. The funds are invested. The money belongs to the employee and goes with him/her in retirement, or upon a job change. Common plans are named 401k, 403b and 457.

Some workers may also have what we call a “defined benefit pension plan” available to them.  In some cases (municipal employees) money is mandatorily taken from their paycheck for this pension.  In other cases (usually corporate employers) the employer contributes the funds on behalf of the employee.

Pension Option = Insurance

This is basically a guaranteed check every month based upon how much an employee earned and how many years of employment. There may be multiple options available as to how to take that money.  The Single Life Option will provide the employee with a monthly check that will cease when the employee dies.  There will likely be some sort of Survivor Option available as well.  One example would be called something like the 100% Survivor Option.  In this case, the employee and spouse will receive a monthly check for both of their lives.  If the employee dies first, the spouse would collect the same check for the rest of his/her life, and vice versa.  As you might suspect, the monthly check for two lives is a smaller number than the monthly check for one life. There are a number of other possible survivor options that may be offered, as well as some options that may have a refund due to the beneficiary when the pensioner dies.  Careful analysis of the retiree’s financial situation must be conducted before an option is chosen.  For the purposes of this paper, we will just use the one life option and 100% survivorship option in the examples we use.

People who choose to take any pension option need to understand that this is insurance. In most cases, the employer gives the funds that it has set aside on behalf of the employee to an insurance company, and it calculates payments for each option based upon the employee’s and possibly employee’s spouse’s ages.  The concept is that a lump sum of money is traded for a guaranteed income stream for the life of the single pensioner or both lives of a pensioner and spouse.  Once the option is chosen, the money is no longer available to the pensioner.  In any insurance situation, money is pooled from many people, and the “law of large numbers” will apply.  Some folks will die before their life expectancy, and others will live beyond their life expectancy.  If a single life pensioner dies at age 70, he/she in effect will pay for another pensioner that lives to 100.  This is how insurance works.  The appeal of a guaranteed check every month for the rest of your life is strong, but it comes with trade offs.

We will do an example or two for illustrative purposes, and then we will discuss the advantages and disadvantages of choosing a pension option.

We will use some numbers quoted from the website  These numbers and rates change all the time and vary by insurance company.  The numbers that you will receive may be higher or lower than the numbers we use.  We just want to give you a pretty good idea of how the process works.  On September 22, 2017, we visited this site and used a 66 year old male and female couple living in Massachusetts.  We assumed that there was $300,000 set aside on behalf of the pensioner.  We also assumed a 100% survivor option.  The monthly check is $1,412.  If the pensioner was a single 66 year old male, the monthly check is $1,667.

According to the Social Security Administration, an average 66 year old male has an 18.4 year life expectancy.  An average 66 year old female has a 20.8 year life expectancy.  In the 100% survivor option above, the female will live on average to age 86.8 and outlive her average husband by 2.4 years.  If that is the case then $1,412/month times 249.6 months (20.8 years) totals $352,435.  If the employee was to compare this option to taking a lump sum and investing it, the math is as follows.  That $52,435, if assumed to be simple interest on $300,000 it works out to 0.84%/year.  In the case of the single male pensioner above $1,667/month times 220.8 months is $368,074.  If that $68,074 is assumed to be simple interest on $300,000 it works out to 1.23% per year.

By the way, it is possible to take a lump sum and do your own pension plan with an annuity sponsored by an insurance company.  The rates may be better than offered through your company.

The good news is that there is a guaranteed monthly pension check that you cannot outlive.

There are disadvantages.  First, the decision to take the pension option is irreversible, that lump sum of money is gone. Second, the checks stop when the pensioner(s) die.  Third, you may die before your life expectancy.  Fourth, the vast majority of pension options available are not adjusted for inflation.  The longer you live, the smaller that check gets with regard to what you can buy with it.  Fifth, there will be no inheritance for your children with the majority of pension options.  Sixth, you cannot stop the checks for a while, if for some reason you don’t need them.  Seventh, you cannot change the size of the check. And eighth, that guarantee that the check shows up is only as good as the company that is sending it.  Some insurance companies are more secure than others.  Also, if your company is large, it may decide to assume responsibility for your monthly payments and not pass it on to an insurance company.  How secure is that company’s financial situation?  There have been previous defaults.  These defaults have been covered by the Pension Benefit Guarantee Corporation, BUT there are caps as to how much pensioners can receive, and some may see their pension checks reduced.

Taking the pension option makes sense for some.  The question is, does it make sense for you.

Lump Sum Option = Investment

The bad news with this option is that you are now taking the risk of providing your monthly retirement check, and the result is not guaranteed. These funds have to be invested in some manner that will provide you a check a month, just like the pension.  If you have had some success with your investment portfolio, or have a trusted financial advisor, you might choose this option. If you have had some bad experiences with your investments, are very nervous about the stock market or the U.S. economy, or are just a very conservative person, the lump sum option is probably not for you. It is not insured.

There are some significant advantages.  First, this is your money, and you are in control of it. Second, you have flexibility with regard to when you take that monthly check and how much it is.  You may start or stop it at any time.  You may choose to give yourself an inflationary raise every once in a while.  You may choose to take some money and take a vacation.  Third, you may leave whatever is left of this money to your children or heirs. Many folks feel strongly about leaving a legacy. Fourth, if properly managed, it is possible to generate as much, or perhaps more income than the pension option. If you have had some success with your investment portfolio or work with a trusted financial advisor, you may view taking the pension option as a pretty poor investment and like your prospects investing the lump sum.

The number of companies that actually have “defined benefit pension plans” discussed above has shrunk dramatically in the last 15 or so years.  The reality is that companies don’t want to be locked in to contributing dollars for future benefits for employees.  They would rather “match” some dollars contributed to a 401k plan.  One result of this trend is that some companies are actually encouraging employees to not participate in “pension plans” in various ways.  For many companies, they would prefer that you take the lump sum instead of the pension option and roll it over to an IRA.  This may or may not be in your best interest.

If you are inclined to take the lump sum, spend some time getting educated about investing and investments.  What asset allocation strategy will you use? What will your “retirement income strategy” be? How big can that monthly check be?  What measures can you take to protect that monthly check from market fluctuations?  How long will your money last? If you have a financial advisor spend some serious time asking these questions.

The Dilemma

Choosing either of these options is a big decision that requires some serious analysis. It is possible that your financial advisor could be biased towards you taking the lump sum.  If you are thinking about taking the lump sum and talking with your insurance professional about an annuity, that person could be biased towards the annuity.  And it is quite possible that you trust both of these folks.  Hmmmm, what to do?

We strongly recommend that you make this decision in the context of your comprehensive, written retirement plan.  Hopefully you already have one in place.  If not, hire a Certified Financial Planner Practitioner who is acting as a fiduciary and have such a plan crafted for you. You should make your decision, after having considered all aspects of your financial situation and your retirement goals.  A fiduciary, by law, must always act in the best interest of his/her clients.

At this time we should disclose our bias.  We think everyone should have a financial advisor who is a Certified Financial Planner Practitioner and who acts as a fiduciary at all times. We all just happen to fit that financial advisor description.

Michael J. McNamara Ph.D., CFP®


*Any financial advice in this article is intended to be generic in nature. Readers should consult with their own financial advisors before implementing any advice or suggestions above.

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