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When you get close to retirement, you could face one of the biggest financial decisions in your entire life. With only one chance to get it right, you can't afford to make the wrong choice.

Dealing with a lump sum
Nowadays, anyone who's covered by a traditional pension plan at work already seems fortunate. With most companies phasing out pension plans in favor of 401(k)s and other retirement plans that rely on employees making contributions rather than employers, you might well figure that anyone who's getting anything from their employer on a monthly basis has a step up on their peers.

But many of those who are entitled to a pension have a big choice to make. You can either accept monthly payments for the rest of your life, or you can exchange away your right to those payments for a big lump-sum payment.

Looking for a smart investment
Until recently, taking the lump sum seemed like the obvious smart move. You could roll over your lump-sum payment into an IRA, which would avoid your having to pay a huge amount of taxes right away. Then you could invest the lump sum however you liked, with the potential to earn much higher returns that would be bigger than the monthly payments you would have gotten from the pension.

But a couple of things have turned that logic on its head. First, the laws that determine how companies figure out how much they have to pay you in a lump sum changed. A recent Wall Street Journal article explained how AT&T (NYSE: T  ) , Chevron (NYSE: CVX  ) , and Dow Chemical (NYSE: DOW  ) were among many employers who have started using these new rules in order to cut lump-sum pension payments by 10% to as much as 60% or more.

The calculations are complicated, but the reason for the reduction in lump-sum payments has to do with the interest rates that companies are allowed to use to figure the proper amount to pay. In 2006, the Pension Protection Act let companies use corporate-bond rates rather than Treasuries to figure lump sums. Because corporate rates are significantly higher -- almost 4 percentage points higher at the height of the financial crisis in 2008, and about 2.5 percentage points higher now -- using them as a discounting factor reduces the value of future monthly payments, thereby cutting the lump-sum total. The WSJ article estimates that those lower payments saved Whirlpool (NYSE: WHR  ) $39 million on its pension obligations. Given that many companies, including Exelon (NYSE: EXC  ) and Xerox, face pension funding shortfalls, savings from lower lump-sum payments could be crucial to their plans' long-term survival.

Not every company has switched to the new rules, which fully take effect in 2012. But many of those that haven't, such as Northrop Grumman (NYSE: NOC  ) and BP (NYSE: BP  ) , have started phasing them in.

How to invest
The other reason lump sums are falling out of favor is that strong returns on investments have largely disappeared. The lost decade of essentially flat stock returns has renewed interest in traditionally more conservative options such as bonds and fixed annuities. Even the federal government is pushing retirees toward guaranteed choices like immediate annuities, which attempt to mimic the monthly payments that traditional pension plans pay.

As a result, it can often make sense to wait and take monthly payments rather than a lump sum. With protection under pension law as well as the Pension Benefit Guarantee Corp., a federal agency that provides pension insurance against employer bankruptcies, you don't have to worry so much about taking the money and running while you have the chance.

If you're given a choice between monthly pension payments versus a lump sum, don't just grab that big lump-sum check. As tempting as it may seem, the lump-sum option may actually leave you poorer than you'd be if you just accepted monthly checks. In any event, since you can't change your mind later, you should definitely take a close look at both choices before you make a final decision.

Pension challenges don't have to threaten your retirement. Click here to read the Fool's new special report, The 7 Secrets to Salvage Your Retirement Today.

Fool contributor Dan Caplinger doesn't expect a pension in his lifetime. He doesn't own shares of the companies mentioned in this article. Chevron is a Motley Fool Income Investor selection. Motley Fool Options has recommended writing covered calls on Exelon, which is a Motley Fool Inside Value pick. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never quits working for you.

Read/Post Comments (3) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 04, 2010, at 8:21 PM, prginww wrote:

    Oh were it so simple as to choose one or the other. You have to consider if the pension is inflation indexed, is it sufficient to survive on, and if may be reduced in the future (think PBGC again)?

    While the new PPA have enabled companies to reduce the lump-sum payout, what is the future value of the current payment based on reasonable assumptions for growth, risk, and the risk-free rate? With all the money that's been/being printed since 2008, those assumptions can be as irrational and wrong as our beliefs in the 2007 housing market.

    Don't be so quick to choose that you choose for the wrong reasons!

  • Report this Comment On December 04, 2010, at 8:27 PM, prginww wrote:

    One more comment: With a pension, you leave nothing to any heirs should you pass prior to your guesstimated date. There may be pension plans with a remainder option, but I'm not aware of any. There are annuity plans which offer that option.

    Choose wisely!

  • Report this Comment On December 06, 2010, at 12:53 PM, prginww wrote:

    If the general premise is that people with a traditional pension are in better shape than those without, what would the logic of taking a lump sum payment? Shouldn't we be recommending these people hold onto whatever pension they have? If the pension was the better chose while employed, isn't it still the better choice in retirement? While each situation is different, in general I don't think an individual can hope to match pension fund returns, or build a risk free cash flow that's better than the pension formula. Let the professionals handle this. I could probably save some money amputating my own leg, but I'm also more likely to bleed to death and that's not a risk I'm prepared to take. Pensions are not about maximum returns, they are about removing risk - big difference.

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