Pension questions: Should I take a lump sum?

John Smith is retiring from a Fortune 500 company that offers a pension plan (also referred to as a defined benefit plan). He and his wife Mary plan to enjoy using some of their pension income touring federal parks in the western U.S. However, they recently received a letter from John's employer with an offer to pay a one-time lump sum amount to John in lieu of receiving the pension income for the remainder of his life. Should they take the lump sum or receive the monthly income?

It's a decision neither is prepared to make.

If you're in a similar situation, we hope you find the following information useful and encourage you to continue to meet with trusted professionals, like your tax advisor, to make the best decisions going forward.

Which alternative may be right for me?

Each person's situation is unique; however, there are generally some areas to think through before making a decision on accepting or rejecting a lump sum offer:

Demographics: What is your age, tenure, marital status, and health?

• Pensions provide a guaranteed lifetime income at retirement and, if elected, an income to your surviving spouse.
• Your life expectancy is a major factor in this decision. If you are in ill health or have a family history of short life expectancy, taking a lump-sum may be an attractive offer versus the income from the pension.
• Your current age is important in considering whether or not to take the lump sum. The earlier you are in your career and/or tenure with the company, the smaller your pension lump sum offer might be — if it is a trivial amount; you may want to consider taking the lump sum offer and investing it for your future.

Desire regarding money: Are you comfortable managing money, and what are your legacy wishes?

• A pension is a fixed income stream. Although the income is guaranteed, you have limited flexibility in withdrawing additional funds. Receiving a lump sum amount gives you access to the funds. However, you'll need to manage the money to provide the needed cash flow in your retirement years.
• With pension income, generally nothing remains for your heirs after you and your spouse pass away (unless you elected your pension over a certain period of years). With the lump sum amount, any remaining funds can pass to your heirs.

Tax considerations: It is important to contact your tax advisor regarding pension lump sum tax rules

• Pension income is taxed as ordinary income. Do you know your income tax bracket?
• A lump sum amount can be rolled over to an Individual Retirement Account (IRA) and avoid taxation when you receive the lump sum. However, any distributions from the IRA will be taxed as ordinary income. If the money isn't rolled over, you'll pay ordinary income tax on the amount of the lump sum. If you were born before 1936, you may be eligible for 10-year averaging, which allows you to average the lump sum as if it were the only income you received over 10 years, at 1986 rates.
• What about the size of your taxable estate? Pension income will not be included in your taxable estate if the income stops at your or your spouse's death. With the lump sum option, the remaining value of the account will be included in your estate.

Again, these considerations should be discussed with your professional tax advisor before you make any final decisions. Here are some other considerations:

• If you took the lump sum, what is your expected future return on the investment and what income could that generate versus the income received from the pension? Are you willing to take the risk that is involved with taking the lump sum?
• Are you and your spouse set on handling the investments or will you let someone else manage your investments?
• What other guaranteed income streams will be available to you? What other assets do you have to meet your income needs?
• Will you be using the money or will you be rolling it over? If the money is not rolled over, you may be subject to a penalty tax for early distribution.

Potential Risks

Before making a decision, understand the following risks:

Longevity Risk

There is a risk with the lump sum, depending on the performance of the investment and how much is needed for income, that you may outlive the funds. You can't outlive the pension income.

If the lump sum is elected you can roll that amount into an annuity to guarantee an income stream for your lifetime. The annuity may allow for income options not available with the pension. Depending on the income option chosen, you may be able to accelerate your annuity payments if you need additional cash. Of course, this will impact your future annuity payments.

Inflation Risk

Inflation can erode your purchasing power. Some pension plans offer a cost of living increase that can help offset the impact of inflation. However, a fixed lifetime pension income payment may result in diminishing purchase power. The lump sum may be invested to meet ongoing income needs. The impact of inflation may be minimized depending on the performance of your lump sum investment. Mutual funds are one option that may help you protect yourself against inflation.

Market and Interest Rate Risk

Your employer assumes the investment risk when making defined benefit pension payments. When you take a lump sum distribution of your pension, you assume the risk of investing the funds to generate retirement income. Fluctuations in the market and low interest rate environments can have an impact on the future value of the lump sum and your available income.

Default Risk

The pension income is guaranteed by the employer, however, that is only as good as the employer's ability to make the payments. What is the current and future financial outlook of the company?

In case the employer cannot meet its obligations, the Pension Benefit Guaranty Corporation (PBGC) guarantees the payment of certain pension benefits. The risk here is that the PBGC insures the benefit only up to certain limits. Visit the PBGC website for more information.

All in all, there are many factors to consider before deciding whether or not to accept a lump sum pension buyout offer. Here are some situations in which the lump sum might be right for you:

• You think you may have a shortened life expectancy.
• You have not been a pension participant for long.
• Feel that you can earn a higher rate of return than what was used to calculate the lump sum.
• You may not need the income or want more control that will allow you to do such things as leave a legacy to your children or favorite charity.

Otherwise, continuing with guaranteed income stream of your pension may be the best choice.