Which is Right for You: The Pension vs. a Lump-Sum

January 4, 2021

Peter Brunton, Chief Investment Officer

After a lifetime of working, everyone deserves a comfortable retirement. If employed by a company that provides pension benefits, you may face an important decision; one that will determine whether you just survive during retirement or thrive. Opt for the stability of a lifetime income stream or elect to take a lump sum and invest.

How do you know what is best for you?

Consistent pension income is a powerful force, but you must evaluate whether that income is enough to provide for all lifetime expenses while also allowing you to accomplish personal financial goals. Key questions that must be addressed include:

  • Is the income enough to offset years of inflation?
  • Does my pension provide enough income to protect against a major medical event?
  • What happens if I pass prematurely, will my spouse be protected?
  • Will I be able to leave heirs a legacy?
  • Can I do better by controlling the assets myself?

The following checklist will provide the foundation necessary to answer these questions and help you make an informed decision.

Forecast all lifetime income and expenses. Then properly apply inflation:

Company pensions provide consistent income, but they typically do not increase with inflation. Many retirees take their total income which consists of the pension + Social Security, then subtract current expenses. If that number is slightly positive, then it is assumed lifetime expenses are covered.

The math makes sense, but if you are a married couple that has reached the age of 65, there is a 75% probability that at least one of you lives to 85 (1). Therefore, expect to have a retirement horizon of at least 20 years. During those years, expenses will consistently grow with inflation. For example, at a 3% rate of inflation, an item that is $100 today will cost $180 in 20 years.

If expenses nearly double over your retirement horizon and the pension stays the same, will you still be positive every year?

That is why it is crucial to forecast 20-25 years of lifetime income and expenses. Use a spreadsheet and create line items for each major expense such as housing, travel, medical, entertainment, food, basic living expenses, etc. Increase those expenses every year with their own custom rate of inflation. Some expenses increase faster than general inflation, others go away completely. For example, medical expenses have historically grown above 5% annually. Yet, travel expenses may completely go away in your late 70’s.

Every year, take total income and subtract the inflation-adjusted expenses. This is your surplus or shortfall per year. Add the total surplus and shortfall for all years. Did the pension still provide enough income? Did you remember to budget for a major medical event or potential need for long-term care?

Can you do better yourself?

To answer this question, you first use a present value analysis to determine the break-even rate of your pension. In other words, the break-even rate is essentially the minimum guaranteed return the lump sum would have to generate to provide more potential lifetime income than the pension.

For example, let us assume John can start collecting $4,000 per month for his life only at 65 or take a lump sum of $650k. If John elects the pension and lives to 83 years old, he receives $864k of lifetime income. Based on the present value calculation, the discount rate is 3.2%.

In other words, if John could take the $650k lump sum and earn 3.2% or better every year on his investments, the lump sum produces more projected lifetime income. In today’s world, nothing is paying you 3.2% without risk and market volatility as an important factor.

A good rule of thumb is to add 1.5% to the break-even rate to offset volatility. That is what a portfolio of stocks, bonds, and real estate would have to produce on average (not guaranteed) to outproduce the pension. Your portfolio will have years of great returns, and years of poor returns. But, in this example, if your average return is 4.7% (3.2%+ 1.5%) or higher, the lump sum is a better option.

Through the end of 2019, a diversified portfolio of U.S. stocks, dividend focused stocks, international stocks, bonds, & real estate produced a 20 year annualized return of 6.9% (2). That is impressive when you factor in this period included two major stock market shocks with the tech tubble and great financial crises.

Do you have other assets? Are they positioned appropriately to cover any shortfall?

Retirement planning professionals often talk about risk-tolerance. Can you stomach the ups and downs of the stock market? Peace of mind is a critical component of a successful retirement strategy.

A pension provides that sense of comfort. However, the bottom line is that a financial plan is going to dictate what risk you need to take. When including a pension, if the forecast of lifetime income and expenses shows a major shortfall, then taking a measured degree of risk may be necessary.

You may have other assets in addition to the pension such as a 401(k). If running at a shortfall due to the impacts of inflation on expenses, those assets typically need to be invested aggressively.

If those assets still do not cover the shortfall, then taking a lump-sum might be the only option.

Evaluate the financial strength of the pension:

Corporate pension plans are extremely challenging to manage. They require the business involved to set aside money and properly predict the returns they can produce to cover a lifetime of income benefits for employees. Forecasting returns has become increasingly difficult, forcing many companies to shy away from offering this benefit.

When making the decision between a pension or a lump sum, your company’s balance sheet strength and credit quality should play a large role. For example, if there is a fiscal issue with the company, there is a possibility that your pension no longer provides “guaranteed” income. Most pensions are protected by a government entity called the Pension Benefit Guaranty Corporation (PBGC). It ensures that even if your company plan becomes distressed, your benefit is not at stake. Check if your specific plan and full benefit is protected by the PBGC when making your choice.

Define your legacy:

Before making the final call, have a clear understanding of your own personal financial goals. If protecting your spouse is a top priority, then choosing a joint life annuity might be the only option. Typically, the joint option reduces the monthly benefit significantly and must be factored into your analysis.

Remember, once you or a spouse (if electing a joint-life pension) die, the benefit is gone. If leaving assets to your heirs is a goal, a pension might not be a good option unless you own other significant financial assets.

Need help evaluating which option is best for you? Please feel free to contact me directly to ask questions or take advantage of a complimentary, pension and retirement analysis.

(1) Source: JP Morgan 2020 Guide to Retirement
(2) Data courtesy of Bloomberg for the 20-year period ending 12/31/2019. Portfolio is rebalanced quarterly. Portfolio consists of 30% Barclays Aggregate (bonds), 30% S&P 500 (U.S. stocks), 15% S&P Dividend Aristocrats (dividend paying stocks), 15% FTSE All-World Ex U.S. (international stocks), 10% NCREIF Property Index (real estate). Simulation does not include fees and is illustrative only as it is not possible to invest directly in a benchmark.

About the Author:

From his homebase in the Bay Area, Peter Brunton performs a multi-faceted role at Strategic Wealth Partners. As Chief Investment Officer, Peter oversees the firm’s investment committee, research personnel, and tactical strategies. With his deep well of experience, he is just as adept at delving into fine details with individual clients as he is concepting... read more...

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About the Author:

From his homebase in the Bay Area, Peter Brunton performs a multi-faceted role at Strategic Wealth Partners. As Chief Investment Officer, Peter oversees the firm’s investment committee, research personnel, and tactical strategies. With his deep well of experience, he is just as adept at delving into fine details with individual clients as he is concepting... read more...

Send a message to
Peter Brunton
Reach Out
Schedule a Virtual Meeting
Book Now