Pension Vs. Lump-Sum Decisions

Ford recently gave its employees in the U.K. the option of taking half of their defined benefit pension as an immediate cash lump sum and leaving the other half as a company pension. Lots of American workers have been offered that option over the past several years as companies look to divest themselves of large retirement liabilities. But it’s often a tough decision for the recipient: Should they take the money and run, so to speak, or leave it where it is, which often provides guaranteed payments for life and some of peace of mind.

Not surprisingly, financial advisors themselves are divided on how to counsel their clients. For one thing, “financial advisors have a conflict of interest when it comes to the pension vs. lump sum decision,” notes David Ruedi, a financial advisor at Ruedi Wealth Management, a fee-only RIA in Champaign, Ill. “If a client chooses a pension instead of a lump sum, there will be no assets for the advisor to manage, which means less revenue for the advisor. For that reason, I feel the best approach to helping clients answer this question is to discuss the financial and emotional considerations involved, so they can make an educated decision about what is best for their life. The ‘right’ answer is ultimately going to depend on the specific details of the pension options, the financial circumstances of the individual, and the emotional makeup of the individual.”

Indeed, every situation is different. Taking the lump sum is better for some people, while holding onto the pension is the best strategy for others.

One important issue -- outside of the client’s own personal circumstances -- is whether the company can be trusted to pay the promised benefits long term.

“In most cases, we advise the client to roll the lump sum into an IRA,” says Scott Tucker, president and founder of Scott Tucker Solutions in Chicago. “Last summer, we advised a former Sears employee to roll her Sears pension into her IRA. Now she’s real glad she did.”

Mike Desepoli of Heritage Financial Advisory Group in Port Jefferson Station, N.Y., agrees, although for a different reason. “More often than not we advise our clients to take the lump sum payment as opposed to defined pension benefits,” he says. “Many of these defined pension benefits do not have an annual cost of living adjustment, and over time that will eat into the value of the monthly pension payments. Taking the lump sum also provides the individual with increased flexibility.”

But Steve Vernon, a retirement education consultant and the author of several books on retirement planning, says his “standard recommendation to older workers is to take the monthly pension, and pass on the lump sum option. Most employees do not have the skills to invest and withdraw from a lump sum payment to last the rest of their lives. My analyses show that it will be very difficult for them to generate more income over their lives by electing the lump sum and investing their savings, compared to simply taking the monthly pension.”

It’s also important for retirees to consider which option gives them greater peace of mind, Ruedi says. “Many people psychologically prefer a guaranteed pension income stream to taking portfolio withdrawals from an investment portfolio. Even if a financial analysis shows the lump sum provides more income or a greater legacy, that doesn’t mean it will allow you to lead a happier life.”

“When I explain the tradeoffs to clients, that is the main thing I stress: Do you want to take the risk of having to manage the money or do you want your former employer to do so?” says David Zavarelli, a certified financial planner in Danbury, Conn. “Clients generally cannot replicate the risk-free return of a pension plan.  They may be able to grow the money to generate income greater than what the plan illustrates, but they will have to put it into the markets and that means they have to have confidence and patience while the investment value rises and falls with the markets.  That is easier said than done.  Many see a loss, then panic and sell.”

But there are some compelling reasons where it makes sense for the client to take the lump sum.

“If the client is in poor health, then it may be advantageous to take the lump sum,” says Michael Menninger, president of Menninger & Associates in Trooper, Pa. If the worker dies, then the pension usually dies with them. But by taking the money as a lump sum, the money is transferrable to their beneficiaries.

One thing most advisors agree upon is that lump sums should never been seen by clients as “mad money” that suddenly lands in their lap.

“The worst thing that can happen is that someone claims the lump sum payment and then squanders it on unnecessary short-term spending,” says Nathan Twining, lead advisor at Financial Plan Inc. in Bellingham, Wash.