How to Choose Between a Lump Sum or Pension

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[Music] hi I'm Andy panko owner of tenant Financial welcome to retirement planning demystified this video will discuss what you need to know when choosing between taking a lump sum or receiving a traditional pension like most retirement planning decisions this decision cannot be made in isolation it must be made in the context of the rest of your financial circumstances for example what are your expected income needs what other sources of guaranteed income will you already have what is your willingness and ability to take financial risk and how important is it to you to maximize how much you altima to leave to your heirs but before we start remember this video is only general explanations and education it's not specific tax legal or investment advice before considering acting at anything you see in this video first consult with your tax legal or investment advisor the lump sum vers pension decision doesn't have a single right answer per se it's always going to be a balance of the pros and cons of each and the weight of those pros and cons will be unique to you and your life and financial circumstances just because someone else decided option a was the right decision for them it doesn't necessarily mean it's also the right decision for you part of the difficulty in making this decision is it's nine apples to apples comparison admittedly yes there are calculations that use current interest rates and your life expectancy to put a dollar value on your pension that dollar value is the pensions lump-sum equivalent but even though there's a number that makes it to mathematically equal there are still two very different things a lump sum is ultimately an investment whereas a pension is essentially insurance longevity insurance it helps protect against you living too long and potentially out living your money over the long term a properly invested lump sum is likely to provide better financial results than taking a pension but maybe it won't there's no guarantee with a pension you know what you're going to get and when you're going to get it and there's value in that safety and consistency with that said let's take a look at the main pros and cons of taking a lump sum instead of taking a pension now I chose to view these from the perspective of taking the lump sum but you can just as easily translate these to instead be from the perspective of pension because every pro for the lump sum is a con for the pension and vice versa the first pro of taking a lump sum is you will have more flexibility with the money you can invest it save it give it away or spend it it's completely up to you with a pension you have no such control ii like i touched on before if invested properly a lump sum has a real good chance of producing a better financial return and receiving a pension but keep in mind this isn't a foregone conclusion it's just based on what the stock and bond markets have done historically you always have to keep in mind that past results are no guarantee of future returns third a lump sum is likely to result in you being able to leave a larger legacy to your heirs with most pensions payments stop when you die or maybe they stopped on both you and your spouse die but after that there's usually nothing left for anyone else with a lump sum because you can't control and invest it there is a likelihood there will ultimately be something left to pass on to your beneficiaries after you die and forth a properly invested lump sum is likely to do a good job of growing and keeping up with inflation on the other hand most pensions are fixed amounts for the rest of your life the payments don't typically increase with inflation over the course of 20 or 30 years inflation can cut your purchasing power in half in other words your $1,000 per month pension today may only have about $500 of buying power in 20 or 30 years now let's look at the cons the first kind of taking a lump sum is that you may run the risk of spending it down too quickly especially if you already have a tendency to overspend if you suddenly come into a few hundred thousand dollars make sure you have the discipline to not frivolous with it second you face investment risk when you take a lump sum at one extreme if you try to keep it safe by doing nothing with it and just parking it in the savings account you'll actually end up losing some of its value anyway because inflation will likely grow faster than your interest earnings or lack thereof or if you invest it too aggressively you run the risk of it having substantial declines in value declines which may not recoup themselves during your retirement with a pension you have no such investment risk third the investment risk you'll face with a lump sum may cause you emotional distress especially if you don't have a high tolerance for taking financial risk since pensions have no uncertainty they generally don't lead to any of the same risk and do stress or anxiety finally there's a risk to outlive your lump sum on the other hand you can't outlive a pension payments lasts until you die now that you know the pros and cons of lump sums worse pensions you can start to give serious consideration to which option is best for you when making the decision use these questions to help you make the best choice for you and your circumstances first ask yourself do I need additional guaranteed lifetime income here's what I mean by that assume you expect your expenses retirement to be about $60,000 per year and assume $40,000 of that is for expenses that are absolute necessities things like housing health care food utilities transportation and taxes the other $20,000 is anticipated discretionary spending or fun money things like vacations dining out extra hobbies and so forth not that those things aren't important but if you really had to you can trim those expenses down a lot unlike the $40,000 of necessary expenses you can't simply choose to stop paying taxes or skip a few months of mortgage or rent payments generally speaking it's a good idea to try to cover as much of your necessary expenses as possible with sources of secure stable and guaranteed lifetime income like social security pensions and annuities because if you do you have the comfort of knowing no matter how long you live or what happens to your investments in the stock and bond markets you'll always be able to at least cover your required expenses let's now look at your income in total you're going to need sixty thousand dollars of income per year to cover your sixty thousand dollars of expenses in our example we're assuming you're going to have 40 thousand dollars of necessary expenses well let's assume you only have thirty thousand dollars of lifetime income from Social Security for example in this case you should seriously consider choosing the pension to help cover some or all the additional ten thousand dollars of necessary expenses if on the other hand you'll already have at least $40,000 of guaranteed lifetime income from Social Security and an annuity perhaps then no you may not need the additional security and income of a pension and should probably lean to are taking the lump sum because so long as you know your required minimum expenses will be covered the rest of your life no matter how long you live you can use your other resources like investments to generate the income necessary to cover your discretionary spending not that you want your investment accounts to eventually run out what if they do you only have to cut discretionary and fun expenses not things like housing or healthcare or food if you already have such a large amount of investable assets that you can easily it conservatively use them to help cover your necessary expenses without substantial risk of your assets running out then maybe you don't need to consider taking the pension second ask yourself am i risk-averse being risk-averse means you do not like taking risk if you're the type of person who will lose sleep over seeing your account values fluctuate as the stock and bond markets move maybe you should consider taking the pension where you'll have no such financial risk well it's hard to put a dollar value on it there is indeed value in the peace of mind you get from not having to worry about what's going to happen in the financial markets third ask yourself am i okay leaving less to my heirs as discussed before with a pension there's typically nothing to leave to your beneficiaries on the other hand a properly invested lump sum could potentially provide you the retirement income you need while you're alive and have money left to leave to your heirs when you're gone and fourth ask yourself do I have above average longevity longevity is how long you expect to live now granted this is a real hard question to answer obviously you don't know exactly when you're going to die but if you have family history of living long or otherwise have reasons to think you may live longer than average you should give serious consideration to the pension because if you do end up living long there's an increased risk of you out living your money and a pension you can help prevent that well this is just an average and not necessarily the assumptions used for your particular pension most pensions typically assume people live until their early 80s if you want to dig into this further you can do a formal break-even analysis to see how long you have to live for your pension payments to equal your lump sum to easily compute breakeven just do a google search for something like lump sum burst pension breakeven calculator you'll find lots of free and easy to use online tools that way let's assume your break-even analysis says you have to live until 82 for your pension to break-even with the lump sum if you think you are likely to live longer than that the pension is better at least on paper but you still have to keep in mind the other pros and cons and life factors we've already discussed you can't boil the decision down to solely a mathematical breakeven now if you answered yes to all four of these questions then it looks like you should lean to are taking the pension but if you answered no to more than a couple then maybe the lump sum is better for you now there's a fifth question to ask yourself but I hesitate to put this in the same list as the other questions because this additional question has nothing to do with you and your unique circumstances and I wouldn't let this fifth question alone drive your decision-making the first four questions are more important the fifth question to ask is our interest rates historically high now all else equal the higher the current level of interest rates the lower the lump sum and vice-versa so if interest rates are high now your lump sum is going to be lower than if interest rates were lower if you've gone through the first four questions and you're still on the fence about taking the lump sum or pension then you can maybe use this fifth question as a tiebreaker but again don't let this question alone drive your decision making given the economic environment we're currently in interest rates are at or near historic lows not highs so all else equal lump sums now or probably the highest they've ever been or close to it now if you do end up leaning towards a pension you also need to consider if your employer and/or its pension plan are financially secure if your pension is from a public employer like a local government or a school district there's likely no backstop or insurance behind the pension system if that government or School District is financially strained and its pension is underfunded there's a risk they may need to eventually reduce pension payments now while it's impossible to say what the likelihood of that is or how much they would reduce payments if they had to it's something to keep in mind nevertheless if the pension system is less than 50 percent funded you probably do need to think about the risk of your pension getting reduced at some point especially now considering how burdened state and local budgets are due to the economic turmoil caused by the corona virus pandemic if your pension is from a private employer the pension will be insured by a federal pension insurance system called the Pension Benefit Guaranty Corporation or PBGC unfortunately the PBGC is having some financial difficulties of its own especially for multi-employer pension plans like those of Union systems where employers employees of various employers are all part of one big pension system even though such plans have federal insurance behind them if push comes to shove the insurance won't necessarily cover 100% of your expected pension payments as for single employer private pensions thankfully PBGC's finances and solvency with regards to those plans are much better shape and show no immediate signs of concern well that's a wrap for what you need to know when choosing between taking a lump sum or a pension a sincerely hope you found this video helpful and if you haven't already subscribe to this channel so you can be the first to know when new videos are posted and don't forget to subscribe to my monthly newsletter retirement planning insights which provides informative retirement planning tips and info also be sure to join my free Facebook group taxes in retirement where you can get answers to all your retirement related tax questions thanks for watching I'll see you soon [Music]
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Channel: Retirement Planning Demystified
Views: 6,241
Rating: 4.8780489 out of 5
Keywords: Pension, Lump Sum
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Length: 12min 58sec (778 seconds)
Published: Wed May 20 2020
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