Traditional pensions are gradually becoming a thing of the past for most Americans, but some workers are still fortunate enough to get them. With many pensions, your employer will give you a choice of whether to take monthly payments for the rest of your life or to take a one-time lump sum payment when you retire. Monthly payments will provide steady income, but a lump sum would give you the opportunity to buy investments that could potentially produce more wealth in the long run. It can be tough to figure out your best option, but this lump sum calculator can help show you the factors involved in making a smart decision. Let's look more closely at how pensions work, and then turn to the lump-sum calculator and how you can use it.
Why pensions offer lump sums
The biggest issue with traditional pensions is uncertainty. No one knows how long workers will live, and so the employer bears the risk that its employees will have long lifespans that will cost the pension plan more than actuarial professionals would predict. By offering a lump sum to workers, the employer gets rid of that longevity risk, and replaces an unpredictable stream of payments with a certain one-time payout.
From the worker's perspective, accepting a lump sum carries similar risks. Rather than having a stream of monthly payments for the rest of your life, you have the responsibility of taking the lump sum payment and investing it wisely. If the financial markets don't cooperate, then you won't be able to generate as much income as you would have received in the traditional pension. However, if markets perform well, then you can end up ahead.
How the lump sum calculator can help you
Making assumptions is crucial in order to help you assess the potential outcomes of taking a lump sum versus steady monthly pension payments, and that's where the calculator can be of assistance. By taking the lump sum you've been offered and comparing it to your monthly payments, you can change variables to see how things are likely to work out.
As an example, say that you're 65 years old and have been offered a lump sum of $150,000 from your pension. If you turn down the lump sum, you'll receive monthly payments of $1,000 for the rest of your life. You could assume a 5% return on investment from a balance portfolio of stocks and bonds, and according to life expectancy tables, a typical 65-year-old lives 21 years on average.
Therefore, you could set up the calculator with an upfront amount of $150,000, potential return of 5%, annual payment amount of $1,000 times 12 or $12,000, no increase in payments, and 21 for the number of years of payments. Run those numbers, and you'll find that the calculator says that taking the monthly payments is the better choice, because their discounted value is about $11,500 higher than the lump sum.
However, if you change assumptions, you'll get different results. For instance, say you have health problems and don't think you'll live as long as your actuarial life expectancy. If you substitute 18 years for 21, you'll find the lump sum is the better option.
Similarly, the better the investment return you can earn on a lump sum, the more likely it is to be the better choice. Boost the 5% return in the original example to 8%, and taking the lump sum has a more than $20,000 advantage over the monthly payments.
Get what you need
There are other factors that can influence your decision about whether to take a lump sum. Regular monthly payments don't give you as much flexibility to handle unexpected situations, because you can't tap into the full value of future payments. A lump sum lets you dip into the entire balance if you need to, but you have to have the discipline not to abuse that ability.
How to take your pension will have a dramatic impact on your finances in retirement. By looking at this lump sum calculator, you can figure out what your best decision will be.