Lump Sum Pension Payment
Drawbacks Include Taxes and Loss of Pension's Survivor Benefits
© John Wu
Nov 7, 2009
Retirees have to make a decision as to how to collect on their pension when it's time to collect. One option is to take a monthly payment from the pension for life. The other option is to take all of the money out of the pension. Although immediate gratification may be tempting, there are many circumstances where a lump sum payout is not a good idea.
Advantages of a Lump Sum Pension Payment
There are cases when a lump sum payout makes a lot of sense. Some people need money for necessities such as medical expenses that require a big expenditure. The pension may be their only source of cash.
Another reason to take a lump sum is if the pension's assumption of future interest rates are low. With lower assumed interest rates, the employer needs to put in more money into the pension. The lump sum payment may be worth significantly more than the value of the monthly annuity in extreme cases such as some executive management pensions where the employer uses a very low future interest rate.
A lump sum may also be a good idea if the retiree does not believe their employer will survive. Underfunded pensions from companies that are struggling may be subject to failing. Failed corporate pensions are guaranteed by the US Government's Pension Benefit Guaranty Corporation (PBGC), but the maximum benefits are limited.
PBGC Maximum Limits 2010
Although the PBGC will pay the benefits of a corporate pension that fails, the PBGC maximum limits can be far short of what was promised by the employer. For example, a pension that fails in 2010 has a maximum monthly benefit of $4,050 at age 65 with survivor benefits and just $1,822 at age 55 with survivor benefits. Airline pilots from employers that went through bankruptcy such as United and US Air experienced large monthly benefit reductions from having their pilot's pension plan taken over by the PBGC.
Taxes on a Lump Sum Pension Payment
To postpone taxes on a lump sum, the portion of the lump sum payment not needed immediately should be rolled into a tax deferred retirement account, such as an IRA. If the lump sum is not rolled over to an IRA, the retiree would likely pay taxes at the maximum federal and state income tax rate due to the size of the lump sum distribution.
On the other hand, a monthly payment for life tends to be taxed at a lower rate because the pension payout is spread out over many years.
Government Pensions Such as CalPERS
In some public pensions such as CalPERS, part of the pension account belongs to the government employer. If a lump sum is taken, the employer portion is not refundable to the retiree. The size of the employer contribution varies from year to year, depending on the investment performance of the pension. If investment results are low, the employer portion of the pension could be quite large.
With government pensions, some of them have generous benefits such as COLAs (Cost of Living Allowance) and 50% survivor benefits that cannot be bought as an insurance annuity without far exceeding the cost of the lump sum. Many of those benefits are funded by the nonrefundable employer portion. Those in generous government pensions should never take a lump sum, but of course not all government pensions are generous.
Retirees should take the time to contact an insurance company and price an annuity with the same features as their pension. If the cost of the annuity exceeds the lump sum, retirees should think twice before giving up their lifetime monthly pension payments for immediate gratification.
References:
Updegrave, Walter. "Pension: Lump sum or monthly payments for life?" CNN Money (June 11, 2009).
Maremont, Mark. "How Some Firms Boost the Boss's Pension." Wall Street Journal (January 23, 2009).
Pension Benefit Guaranty Corporation (PBGC).
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