Pensions: monthly payments v. lump sum

If you're confused about how to take your pension, ask yourself these five questions first.

Question: My wife is retiring early next year at age 50, although she still plans to do some part-time work. Should she take her company pension as monthly payments for life equal to $1,800 a month, or should she take it in a lump sum of $360,000? —Jeff, Green Bay, Wisconsin

Answer: Ah, the check-a-month-for-life vs. take-the-money-and-run decision. To quote the King of Siam in the Broadway musical The King and I, “Is a puzzlement!”

Regular payments are definitely appealing. It’s nice to know that you’ll have a check coming in every month regardless of what’s going on with interest rates and the stock market. That kind of security is valuable not only in a financial sense, but emotionally too.

But it’s not as if the lump sum doesn’t also have its advantages. Taking your company pension and rolling it into an IRA account (which you would do to avoid paying taxes immediately on the lump) clearly gives you more flexibility. You can decide to draw more in some months, less in others, or none at all, for that matter. And if you invest and manage the money wisely, you may very well be able live off it the rest of your life and have some left over for heirs.

Clearly, this isn’t a question that lends itself to quick and easy answers. That said, I think that given what you’ve told me about your wife’s situation, you should probably go with the lump sum. Before I get to the rationale behind that conclusion, however, I’d like to propose five questions people facing this decision ought to ask themselves before committing to either option.

1. How much guaranteed income will you need?

As appealing as the regular-payments-for-life option may be, remember, at some point you and your wife will also begin collecting a guaranteed monthly income from Social Security. What’s more, your Social Security payments, unlike those from most company pensions, will rise along within inflation.

Now, what’s plenty of guaranteed income for one person may not be nearly enough for another, so you and your wife will have to decide how much is right for you. But one way you can at least evaluate how much assured income you need is to estimate how much you must spend on essential retirement expenses - housing costs, utilities, food, medical care - and then see what portion of those expenses Social Security will cover. If it takes care of most of your basic living costs, then perhaps you don’t really need that much more guaranteed income.

To get a handle on your retirement expenses, you can check out the interactive budgeting worksheet that’s part of the Retirement Income Planner tool at Fidelity’s web site. For an estimate of how much Social Security you and your wife might receive, check out the Social Security administration’s new, more accurate Retirement Estimator.

Of course, your wife still has a good number of years before she can actually begin collecting benefits (62 is the minimum age). But if it appears that Social Security will provide enough assured income once you begin to collect it, then you and your wife may be better off getting by on other sources of income (her part-time work, your income or Social Security, draws from retirement assets or the lump sum itself) until Social Security payments kick in.

2. How good a deal are the pension payments?

If your wife takes her pension as payments for life, she’s essentially buying an immediate annuity (aka an income annuity) from her company - that is, she’s trading her lump sum for a type of annuity that will make fixed payments for life. Is that a good trade?

One way to tell is to see how much income your wife could get if she took her $360,000 and bought an immediate annuity from an insurance company. And if you go to ImmediateAnnuities.com, you’ll see that with $360,000 a 50-year-old woman can buy an immediate annuity that will pay roughly $1,800 a month not just for the rest of her life, but as long as her spouse is alive as well. (This option is known as “Joint Life Income with 100% to the survivor.)

In fact, your wife can probably do a bit better. For one thing, the quotes at this site represent an average, which means some insurers will pay more. And the $1,800 a month quote I got at the site assumes you and your wife are the same age. If you’re older than her, the payment will be higher.

Keep in mind, though, that the fixed annuity payment your wife would receive depends on, among other things, the prevailing level of interest rates. So she’ll want to make this comparison again next year when she’s closer to retirement. But at this point at least, it appears that the monthly payment option offered by her company isn’t as attractive as what she can get elsewhere.

3. How confident are you investing a lump sum?

Proponents of taking the money and running often note that by investing in a diversified mix of stocks and bonds, you should be able to earn a higher return and thus draw more income from a lump sum than you can get by investing in an annuity.

And, theoretically, they’re right. The assets backing immediate annuities are essentially invested in bonds, which typically pay lower long-term returns than a portfolio of both stocks and bonds.

But that assumes that you’re willing and able to put together a well-balanced portfolio of stocks and bonds and managing it during tumultuous periods like the last few years - and that the financial markets deliver decent returns.

I don’t want to suggest that retirees cannot or should not manage their retirement assets. I believe most can. But before opting for a lump sum, you certainly want to consider the extent to which you want to take on the responsibility of investing that money, or paying someone to do it for you.

4. How much do you have in other savings?

There will likely be times during retirement when you need extra cash to pay big medical bills, repair your home, replace a car, fund a splurge or cover emergencies or other unanticipated expenses.

If you opt for the check-a-month option, however, you give up access to whatever amount of money you could have received as a lump sum - $360,000 in your wife’s case. That may not be a problem if you have other savings to draw on - money in IRAs, 401(k)s or other retirement accounts. But if you’re relying primarily on Social Security and your pension, then opting for the monthly payments may limit your flexibility to meet unforeseen demands down the road.

So ideally you want to arrange your retirement finances so that you’ll have not just regular income flowing in, but a pot of savings you can also draw on when you need it.

5. How solid is your company?

Although we think of monthly pension benefits as income we can definitely count on for life, the fact is you’re relying on your employer having the financial wherewithal to make those payments for decades. But as we’ve seen in several cases - notably steel companies and airlines - sometimes employers aren’t able to meet those obligations.

The Pension Protection Act of 2006 contains a number provisions designed to bolster pension security. And the Pension Benefits Guaranty Corporation provides a safety net in the event an employer can’t make required payments (although that protection has limits).

But before giving up a lump sum in favor of monthly payments, you at least want to take the financial health of your employer into account and consider how you might fare if your payments were interrupted or even reduced.

If you and your wife go through these questions and apply them to your situation, I suspect you’ll probably opt in favor of the lump sum. In short, I think that taking the lump sum will probably offer you more flexibility and options for managing your income in retirement.

So before you make a decision, make sure you’ve got the correct information from your wife’s company about her pension and then assess your situation along the lines I’ve outlined - or have a financial planner do it for you.

Because if you proceed without doing this sort of evaluation, you’re basing your retirement security on guesswork, not an informed choice.