If your employer offers a pension plan, congratulations! Fewer businesses today are offering traditional pension plans to employees, instead opting for defined contribution plans like 401(k)s.
Assuming you have a pension plan, you may be given the option at some point of receiving a lump-sum financial payout or monthly payments over time. Many large businesses with pension plans are offering employees lump-sum payouts in order to limit their future pension obligations and long-term financial commitments.
The 6 Percent Rule
So which option is better — a lump-sum payout or monthly payments? The answer will depend on the details of your particular situation, but there are some general guidelines you can follow.
One guideline cited by some financial experts is referred to as the “6 percent rule.” According to this rule, if the monthly pension payment equals at least 6 percent of the lump-sum payout, taking the monthly payment may be the best option. Conversely, if the monthly payment equals less than 6 percent of the lump-sum payout, taking the lump-sum payout and investing it may be the best option.
The calculation looks like this: Monthly payment x 12/lump-sum payout
For example, let’s assume you’re offered a lifetime monthly payment of $1,000 starting when you turn 65 years old or a $160,000 lump-sum payout:
$1,000 x 12 = $12,000/$160,000 = 7.5 percent.
If you took the lump sum and invested it yourself, you’d have to earn a 7.5 percent annual return in order to generate $12,000 a year. While this is certainly possible, it’s far from a given, especially over a short- to medium-term timeframe. Therefore, taking monthly payments could be a better option.
Now let’s assume you’re offered a lifetime monthly payment of $700 starting when you turn 65 years old or a $170,000 lump-sum payout:
$700 x 12 = $8,400/$170,000 = 5 percent.
In this example, you’d only have to earn a 5 percent annual return in order to generate $8,400 a year. This is less than the 6 percent benchmark, so taking the lump-sum payout and investing it could be a better option.
Other Factors to Consider
There are other factors you should consider in addition to the 6 percent rule when deciding which pension payout option is best for you. These include the following:
- How old you are when the monthly payments would begin compared to your age when you would receive the lump-sum payout.
- Your anticipated lifespan. Of course, no one know exactly when they’re going to die, but your current health condition and family history can give you a clue to your longevity.
- Your employer’s financial stability. If you choose monthly payments, you want to be confident that your employer will be able to make these payments over the long term. Check to see if the pension plan is insured by the Pension Benefit Guarantee Corporation (PBGC).
- The type of pension payout you choose. Your plan may offer several different types of payout options. For example, it could be based on your life only or there could be provisions for your surviving spouse. Or there could be a “period certain” option that pays your beneficiaries for a period of time even if you die soon after receiving monthly payments.
- Your potential needs for a large sum of money or desire to leave assets to your children and heirs.
An Important Financial Decision
The decision you make about a pension plan distribution is an important one – it could have financial ramifications for many years to come and affect your ability to live comfortably in retirement. So take the time to do the math and also consider these other factors in order to make the best decision for you and your family.
Please contact us if you have more questions about taking pension plan distributions.