Traditional pensions are an endangered species in the private sector. But if you're lucky enough to have one, you may face a choice at retirement: Take the money as a lump sum, or as a monthly lifetime annuity-style payment?
About one-third of private sector workers who have traditional defined benefit pensions are in plans that offer this choice. And most of them opt for a lump sum, partly because it can sound like so much money, and partly because of all the bad news we've seen in recent years about big pension plans that have gone belly up.
But lump sums usually a bad deal. Most people would come out far ahead over the course of retirement with an annuity. And, lump sums are getting to be even less attractive due to recent pension reform legislation that mandates changes in the way lump sum payments are calculated.
Pension plan sponsors calculate lump sums using longevity and interest-rate statistics, aiming to match the amount you'd need to invest to match the annuity-style checks you'd receive from your normal retirement age. In that sense, the choice between lump sum and annuity should be neutral, producing the same result over time.
But that's not the case. While the outcome depends on a number of factors--how you invest the money, whether you're a male or female, and whether you're married--most people will come out ahead with an annuitized pension. Here's why:
Say, a retiree is entitled to a monthly pension of
Human behavior and market risk
Now, let's consider the lump sum. For starters, our retiree must invest it to generate lifetime retirement income. In addition, she runs the risk of withdrawing too much, market setbacks, or living much longer than average -- creating the need to stretch her nest egg much further.
Some retirees worry that their pensions won't be there for them if their employer experiences financial catastrophe. Indeed, defined benefit pensions have gotten a good deal of bad press as a result of high-profile failures of underfunded plans at companies such as
But pension safety is improving due to passage of the Pension Protection Act of 2006 (PPA), which includes important reforms that require all plans to get to 100 percent funding over a period of years.
It's also important to know that most private plans are insured by the
When the PPA was passed, plan sponsors lobbied successfully for a change in the benchmark interest rate used to calculate lump sums. They argued that lump sum payments were being inflated artificially by ultra-low 30-year Treasury rates. The PPA replaced the Treasury rate with a higher composite corporate bond rate that will be phased in fully in 2012. The corporate rate is a little over 100 basis points higher than the Treasury rate.
"All other things being equal, it means a lower lump sum," says
Women get an especially bad deal. The actuarial tables governing lump sum calculations are unisex, but women outlive men, on average, by about four years. That means female workers who take lump sums get shortchanged.
Early retirement can be a pothole. Many employers offer older workers pension incentives to retiree early, but they aren't required by law to include those sweeteners if you take a lump sum.
"Let's say you'd get a
A lump sum can make sense in some situations, Glickstein says. "The key factors are how long you're likely to live, and what you plan to do with the money. For example, say you're married and your spouse receives a monthly pension. You might want to take the lump sum to invest in a business or travel. Look at the whole family's circumstance."
"But if this pension is going to be your primary source of income in retirement alongside
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