Should You Accept Your Pension or Take a Lump Sum?
You’re approaching retirement and you are offered a choice regarding your pension. Should you accept the lifetime monthly payments or withdraw the commuted value (lump sum)?
Which is better?
Both choices have their pros and cons. Take the time to understand what the options might mean to you and your family. There are many factors to consider.
Here is a run down of some of the considerations for choosing between monthly pension payments and a lump sum.
Whether you have a defined benefit plan or a defined contribution (money purchase) plan, it’s designed to provide you with income for life.
When you pass away, your spouse or common-law partner may be entitled to a survivor benefit for life.
Some pension plans are indexed to inflation, effectively giving you an annual “raise” based on the Consumer Price Index.
Assuming the plan and the employer are solvent, no matter what happens to interest rates or volatile financial markets, with a pension you can count on that money coming in, month after month and year after year.
Monthly payments are a great option for retirees. It helps you stick to a budget and it’s easier to keep your spending under control.
For most this will be the better choice. Better income security – guaranteed for life. Add that payment to CPP and OAS and hopefully you can meet your expenses each month.
In addition, at any age, you can split up to 50% of pension income with your spouse which provides significant tax savings.
One major drawback with a pension is there’s no possibility of accessing the principal. Based on your financial situation, it may be necessary to make sure you have other funds available to help you cover unexpected expenses.
If the pension is fixed (not indexed) inflation will erode its value and you will lose purchasing power over time.
Once you die (and your spouse if there’s a survivor benefit) the monthly pension payments stop. There is no residual value to your estate.
There is a possibility that an employer could be in financial difficulty and find itself unable to pay retirees. It may be remote, but it has happened. Look at Nortel in Canada and K-Mart in the US.
There are so few guarantees in life. Why would anyone fortunate enough to have a pension take a lump-sum payment instead? If you have enough retirement savings, you may not need the pension to feel financially secure.
A lump sum payout is a tempting option. If you are a long-time employee, the number may be in the hundreds of thousands of dollars. It may be the largest single disbursement of money you will ever receive. In fact, lump sums are higher when interest rates are low as they are now. This explains why it’s a popular choice these days.
It makes sense to withdraw your pension’s commuted value if you and/or your spouse are in poor health and likely to die much younger than average. You’ll be able to spend more now or leave a larger estate.
One advantage with a lump sum is the flexibility. You’ll have more control over your money and be able to invest exactly how you want. Maybe you are confident that you can achieve favorable investment returns, outperform the pension fund, and generate enough income to last your lifetime.
If you plan your investments and withdrawals right, you’ll be able to leave the rest of your lump sum to your beneficiaries. This can help set you mind at ease knowing that your family is well taken care of.
It gives you the freedom to spend what you need in retirement, when you need it, especially unexpected costs.
However, the money is not necessarily available to you right away. Legislation may require the funds to be deposited to a locked-in account (LIRA or LIF), with restrictions placed on the amount you can withdraw each year.
There are a few downsides to the lump sum payout option.
If you were with your employer for many years and the commuted value is large, a sizeable amount will be taxed immediately at your highest marginal tax rate. If you have RRSP contribution room, you can shelter as much as possible to offset the tax.
You’ll have to be significantly more disciplined with your investing approach. Investment volatility can affect growth. It’s easy to overestimate your returns with the current market. There’s a chance that your portfolio won’t produce an amount equal to your pension without taking on significant risk. Plus, with life expectancies on the rise, who’s to say that a lump sum will actually last you through retirement or beyond?
Keep in mind that a lump sum pension payout makes it easier to overspend in retirement. That new car or luxurious vacation may not seem like such a splurge when you’re looking at a six- or seven-figure bank account. In fact, a 2016 Harris Poll study of retirees revealed that 21% of pension plan participants who took a lump sum depleted it in 5.5 years.
Which option is best for you?
One valuable part of pensions is that they keep paying you even if you live a long life. In other words, they take care of longevity risk.
Should you withdraw the commuted value? The answer is almost always no if you are about to retire. Pension payments are generally the better way to go, but the answer isn’t that black and white.
The choice is based on many factors. If you think you have a long life ahead of you or if you’re more comfortable budgeting a regular income, you’re better off with the lifetime monthly payments.
If you think the lump sum amount will wind up being larger than the pension payments, or you like the flexibility to spend and invest as you see fit, then go with the lump sum.
You need to make your choice well before retirement. This is a one-time decision that can’t be reversed.
Related: Determining Your Retirement Income