A pension may seem mythical to you young folks, but there are still many Americans who have pensions. If you are one such American you are about to be faced with a huge decision. Imagine yourself at the age of 62, you’ve planned and prepared and today you are retiring. But there’s one last decision to make, you have to decide if you’ll have your pension distributed annually or in a lump sum. Not quite the life-changing decision you were expecting? Actually, despite the simplicity of the either/or decision, the choice can have quite dramatic results. For this example, we’ll say your choice is between receiving your pension as a $30,000 annual pay-out for the length of your life, or getting a lump sum of $375,000.
Which would you choose?
This week I took to my Indy Star column to give you my best advice on how to handle this momentous pension decision. For this example, let’s assume you chose the second option, $375,000 right now. Obviously this money is intended to last for a good long while so you do the seemingly responsible thing and you draw $30,000 each year.
“If you distributed $30,000 from the $375,000, you would be bleeding 8 percent off of the initial principle, regardless of investment return. A vast majority of financial experts agree that retirement distribution rates should stay around 4 percent or less. An 8 percent distribution, as just discussed, would be a recipe for disaster.” (courtesy of the Indy Star)
Here you are thinking you are doing the most responsible thing, and bam! you realize you are going to run out of money much quicker than you anticipated. Not quite the retirement gift you were looking for, huh? By taking your pension out in a lump sum you are taking on all the risk yourself.
“A Monte Carlo simulation of a portfolio made up of 60 percent stocks and 40 percent bonds suggests that an 8 percent distribution rate over a 25-year period has a 32 percent chance of success. In other words, you would have a 68 percent chance of running out of money. This risk is completely absorbed by you when you take the lump sum. When you take the pension payment, this risk is absorbed by the pension fund.” (courtesy of the Indy Star)
The math is obvious, but sometimes decisions about money aren’t about math. Actually, I’ll go ahead and say decisions about money are rarely if ever about math. You make decisions about your money based on behavior and emotions. So what emotion is urging you to choose a lump sum despite the math? Fear. You’re afraid the market and economy will impact your pension. I get it, but honestly if the market and economy are doing poorly your lump sump probably won’t be doing any better.
“Despite all the factors we just covered, this still isn’t a slam-dunk decision. For instance, you need to understand that the 8 percent distribution factor we used in the first example is about the highest factor you will find from a pension plan. At some point, the factor gets so low that it would make more sense to take the lump sum. Additionally, an unhealthy individual should most likely consider taking the lump sum. A person who already has a tremendous amount of fixed monthly retirement income would also be more likely to take the lump sum.” (courtesy of the Indy Star)
If you have a pension you will have to make this decision at some point. Start to process the information now, so you can make a decision with a clear head.
Read the rest of my column here.
Peter Dunn a.k.a. Pete the Planner® is an award-winning financial mind and a former comedian. He’s a USA TODAY columnist, author of ten books, and is the host of the popular radio show and podcast, The Pete the Planner Show. Pete is considered one of the foremost experts on financial wellness in the world, but he’s just as likely to talk your ear off about bass fishing.
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