Retirement is looking better and better. Your former employer just offered you a big sum of cash in lieu of your monthly pension payments. And money today is always better than the promise of money tomorrow, right? Not so fast.
You're not the only one weighing this decision. General Electric ( GE -3.46% ) recently announced key changes to its pension plan, including a new buyout option available to about 100,000 former employees. The news follows a Treasury Department rule change earlier this year that allows more companies to offer these buyouts.
So, what is a lump-sum buyout, exactly? It's essentially a trade. You, as a retiree, get a single cash payment today in lieu of your lifetime monthly pension payments. And while that cash windfall might feel like a lottery win, it's often not the right financial move. Here are five reasons why.
1. You aren't sure how the lump sum is calculated
The Internal Revenue Service has rules in place to ensure your lump-sum buyout offer is a fair approximation of your total future pension payments. But converting a stream of monthly payments into its current value is not an exact science. There are assumptions involved -- namely, the interest rate and the number of years you'll collect the monthly payments.
Even though the IRS dictates those numbers, they're still assumptions. The biggest question mark is how long you'll live. If you outlast the IRS's life expectancy assumption, the lump-sum buyout ends up being a bad deal for you. That's because the lump-sum wasn't intended to last that long. Had you kept the monthly pension, though, the payments would last as long as you do.
While you can't predict the future, you should understand the nature of the trade-off before accepting that one-time payment. Ask a trusted financial advisor to review the numbers with you or use a pension calculator to check the numbers on your own.
2. You are healthy
If you play pickleball three times a week, meditate daily, eat clean, and always have a refillable bottle of filtered water on hand, congratulations -- you may have your best days ahead of you. That's the good news. And the bad news? You might outlive your lump-sum pension payment.
According to the Social Security Administration, "about one out of every three 65-year-olds today will live past age 90, and about one out of seven will live past age 95." But lump-sum payments assume you'll live an average lifespan. If you plan on outlasting the average Joe or Joanna, your pension is worth more to you as lifetime monthly payments.
3. You like to shop
Consider any history you've had with cash windfalls, even small ones. Have you spent tax refunds on the day the check arrived? Or made big purchases with your annual bonuses? Or even borrowed against your home equity line to take a nice vacation?
Know yourself and your spending habits. If you're a big spender when you have the cash on hand, the lump-sum option probably isn't going to work well for you.
4. Budgeting isn't your strong suit
Indulging on big-ticket items isn't the only way to run out of money. While it's decidedly less exciting, you can also use up your lump-sum funds by overspending small amounts over time. The only way to know how long your money will last is to crunch some numbers and define a clear retirement budget.
The bottom line is, you need to understand what you can afford to spend each month, and how that budget affects your cash balance over time. And then there's the hard part: being disciplined enough to stick to that plan.
5. Your investment track record is spotty
Accepting a lump-sum payment is easy. But managing that money over time is not. There's a gentle balance between protecting your funds and maximizing them. You leave money on the table if you tuck your pension away in a low-rate savings account. But chasing high returns isn't a good idea either. The sweet spot is 5% to 6% growth annually, which you can accomplish by investing in low-cost ETFs or mutual funds. If you do plan on picking stocks, hold more than 20 to keep your portfolio diversified.
When you choose the monthly payment option, your plan administrators decide how to invest the money and they absorb the risk. Even if your pension plan goes bankrupt, you're still protected by the Pension Benefit Guaranty Corporation. The biggest decision you make is where to deposit your monthly check.
The lump-sum option is riskier
A cash windfall may sound fun, right up until you realize you're going to outlive your savings. If you expect to stick around for the long haul -- and you don't want the risk and responsibility of investing -- pass on the money today to protect your cash flow tomorrow.