Taking a pension in a lump sum offers the benefits of flexibility and complete control, but carries the risks of running out too soon, as well. Electing a lump sum over an annuity payment means that a retiree gets all of his money up front. Depending on how the plan is structured, however, it can also mean that less money is ultimately transferred. There is usually more risk for poor personal investment decisions with a lump sum, as well. Pension lump sum payouts always carry both pros and cons, and making the right choice usually involves a careful weighing of each.
A traditional pension payment is a fixed monthly amount that is paid to a retiree until he or she dies. At death, the payments usually cease. In a pension lump sum situation, however, a larger amount of money is paid to the retiree upfront, and the retiree is free to do with that money as he wishes.
Most of the time, people who elect pension lump sum payments immediately reinvest the proceeds, usually by placing them in a personally-controlled retirement account. Any money that is simply distributed to the retiree is fully taxable in most jurisdictions, which can be a major drawback. Reinvesting pension lump sums can avoid negative tax consequences in most jurisdictions.
For many people, the ability to personally control the lump sum and its distributions is one of the biggest benefits to the pension lump sum option. Sound investment choices can often yield greater returns than fixed monthly payments would. Fixed payments are not often adjusted for inflation or cost of living increases over time.
In case of unexpected crises or financial needs, money can be tapped from the lump sum, which is another plus. Fixed payments do not usually permit early withdrawals or advances. Additionally, money that is distributed in a lump sum is the retiree’s to keep — even if he dies immediately thereafter. With annuity payments, once the retiree dies, the payments simply stop.
Of course, there is always the risk with a pension lump sum that a retiree will live far longer than was anticipated. In most cases, lump sums and annuity payments are both calculated based on a retiree’s average life expectancy. If an annuity-plan retiree lives longer than expected, he will still continue collecting payments, as stipulated by the plan. Once a pension lump sum has been distributed, however, the distributions are done.
For an inexperienced investor or anyone who struggles with money management over the long-term, a pension lump sum can be dangerous in that it can be quickly spent. Most of the time, lump sums come with no strings attached. A retiree who spends his lump sum within the first years or months of ownership might find himself ill prepared for the future.
Weighing the choice between lump sum versus pension payments is often a difficult and complex endeavor. The difference between the options depends on a lot of different factors. Getting a clear sense of the pros and cons of a pension lump sum usually requires a careful reading of all pension plan documentation, as well as consultation with both a corporate human resources representative and a personal financial adviser. In some cases, the pros might outweigh the cons — but not always.