What to consider before taking the lump sum

If presented with the option of getting a pension check for life or getting a lump sum, what’s the better deal? Getting a monthly annuity certainly has a certain allure — you get a steady paycheck for life.

But getting a lump sum can be a more attractive option if you manage the money well. Why? The biggest drawback of an annuity payment is that pensions are rarely indexed for inflation. At an annual 3 percent inflation rate, a monthly check worth $2,000 today would be worth $1,488 in 10 years, and $1,107 in 20 years. That’s a huge reduction in purchasing power.

Also, it’s not the best time to arrange for a pension check because annuity payment calculations are based on prevailing interest rates. In a low-interest rate environment like we have now, getting an annuity would involve locking in a low rate of return for the rest of your life.

Some economists are predicting increasing inflation in the near future. One of the things inflation pushes up is interest rates, so taking the fixed rate annuity offered by most company pensions can leave you unnecessarily strapped. Taking the lump sum allows you to invest the money for the short term until interest rates are more favorable.

Consider these other issues before taking the lump sum.

Insure against longevity

If members of your family live a long time — to age 90 or even 100 — taking the lump sum gives you more flexibility and the power to invest aggressively to make your money last longer. “You have every investment in the world available to you and you can allocate the money any way you want,” says Louis Scatigna, a Certified Financial Planner from Howell, N.J.

The flip side, of course, is that an aggressive strategy is risky, so you risk loss of principal in an uncertain market environment, and it can take many years for your portfolio to rebound. If you pay someone else to manage your money, there’s still no guarantee you’ll make money every year. And you pay substantially for the service. A 1.5 percent asset-based fee siphons $7,125 annually from a $475,000 lump sum.

Of course, you don’t have to touch your investments if you don’t want to. As long as you have other resources, you can let the money sit during years when there are losses or returns are very low.

Tax benefits

You’ll owe federal income taxes on every monthly pension payment. But with a lump sum, you don’t have to pay the tax man if you don’t need the money. If you roll the lump sum into an IRA, you’ll only be taxed on the money that you choose to take out each month. Beginning at age 70½, the IRS insists that you withdraw a certain amount and pay taxes on it, but because minimum required distributions are low, the tax owed would likely be less than with a monthly pension.

Benefits for beneficiaries

When you die, the money that’s left goes to your heirs. The company annuity ends when you and/or your spouse dies. Your children get none of it. If you take the lump, your spouse gets the money after you die, and when she dies, your heirs get whatever remains.

When lump sums are not beneficial

In some situations, though, taking the lump sum would force you to leave money on the table. For example, many companies subsidize early retirement in order to get workers to leave their jobs. They aren’t required to factor in the value of the subsidized retirement when they calculate the amount of the lump sum option some companies offer to retirees. They do have to tell plan participants about the relative value of a subsidized benefit compared to the lump-sum payout.

It can be hard to read the required explanation, but get help. Sometimes getting the subsidized benefit gives the company’s early life annuity participants as much as 50 percent more, the Pension Rights Center points out.

Also, lump sums can be difficult to manage even among seasoned investors. Older people run the risk of mismanagement due to poor heath, particular if Alzheimer’s disease becomes an issue.

“The wheels start coming off as people age. When you have dementia, you don’t know that you are falling off a cliff,” says Robert Katch, president of Manchester Financial, based in Westlake Village, Calif. “People make mistakes that they don’t know they are making and they end up in a mess.”

And some people, even with all their senses intact, cannot manage to hang onto money to save their lives.

The trade-offs between taking a monthly pension check or the lump sum should be analyzed in great detail. If you find yourself in this situation, be sure to hire a qualified financial planner to help you run the numbers and consider various scenarios before you make a final decision.

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