What to Consider Before Taking a Lump Sum Buyout of Your Pension

Jane Young, CFP, EA

In an effort to decrease pension obligations, many corporations have been offering current and former employees a lump sum to buyout their defined benefit pension plans.   At first glance this may seem like a great opportunity and pension administrators say that 50% to 70% of those offered take the lump sum.   Analyze this carefully; it’s an important and complex decision that is different for each individual situation.

Generally, the lump sum offer is based on an actuarial calculation indicating the present value of a pension’s income stream, based on your age and a reasonable rate of return.  You can evaluate the relative value of the lump sum being offered by calculating the internal rate of return of the income stream or by running present value calculations using various rates of return and life expectancies.  A fee-only financial planner or an accountant can help you with these calculations.

Life expectancy, which is readily available on the internet, is one of the biggest factors in determining the advisability of taking a lump sum.   However, the typical life expectancy may not be applicable to you.  Healthy individuals with a history of longevity in their family may live longer than the standard life expectancy.   Alternatively, individuals with health issues or a family history with shorter life spans may anticipate a shorter life expectancy.  Generally, monthly payments from a pension are better if you anticipate a longer life expectancy and a lump sum is better if you anticipate a shorter life expectancy.

Other considerations include having the discipline to invest the funds from a lump sum to be gradually used throughout retirement rather than spending the entire amount over a short period of time. Also consider your comfort with investing the lump sum and your willingness to take some risk to earn a reasonable return.    A lump sum may be a good option if you need access to a large amount of money in the short term.

It’s good to strike a balance between fixed income streams that can provide more certainty and an investment portfolio that is more volatile with the potential to earn a higher return.  If you have another pension consider a lump sum and if you don’t have a pension, a fixed income stream may add some stability to your financial situation

Another huge factor in the decision is the safety of your pension.  Pensions offered by most public corporations are insured by the Pension Benefit Guarantee Corporation (PBGC) up to a limit of around $60,000 for a single life and $54,000 for a 50% survivor benefit.  Unfortunately, state and local pensions are not covered under the PBGC.   The pension administrator can tell you if your pension is insured by the PBGC and how well it is funded.   Anything under around 80% is a red flag.  If your pension is not insured and is not well funded it may be wise to take the lump sum.

Pre-retirement Checklist for a Worry Free Retirement


Jane Young, CFP, EA

Retirement represents a huge change in your lifestyle and finances.  Plan and prepare ahead of time to enjoy a comfortable and rewarding retirement.  Think about what your retirement looks like – will you retire completely or will you gradually transition into retirement?  Consider transitioning from your current career to a part time job doing something you really enjoy.  Think about what you will do in retirement, where will you live and what kind of lifestyle you want.

Consider the emotional impact of retirement.  Generally, your career provides a major sense of accomplishment, meaning and significance.  Most of your social life may also come from work relationships. Seriously consider the impact retirement may have on your self-esteem and personal identity.  Explore ways to spend your time in retirement on meaningful and rewarding pursuits, in addition to the fun activities you previously had no time for.

Evaluate your current spending habits and develop a realistic retirement budget.  Remove expenses you will no longer incur such as contributions into a retirement plan and add expenses that may increase in retirement such as additional travel and insurance expenses.  Build in some flexibility, plan for unexpected expenses and maintain an emergency fund.

Discontinuation of employee benefits, upon retirement, will probably result in the need for additional health and dental insurance.  Research Medicare costs and coverage along with the cost of supplemental health insurance that may be needed.  Think about how you may cover the possibility of long term care expenses and evaluate buying long term care insurance.  As you approach retirement you may be able to reduce or discontinue life and disability insurance coverage.

Manage your debt and take care of major maintenance or remodeling projects prior to retirement.  To the extent possible, pay off credit cards, vehicle loans, student loans and your mortgage.  If you can’t pay off your mortgage but plan to refinance, do so prior to retirement.  It may be difficult to refinance after retirement when you have no earned income.

Review your Social Security and Pension benefits and make some preliminary decisions on the best time to begin taking benefits.  Consider the possibility of losing a spouse when making these and other major retirement decisions.

Run some retirement planning scenarios with a financial planner to determine when you can afford to retire and how much you can afford to spend in retirement.  Based on these scenarios develop a plan to create a tax efficient income stream to pay expenses that aren’t covered by Social Security or Pensions.

Develop and implement an investment plan to support your short term income needs while providing reasonable growth to carry you through retirement.   Your short term money should be held in safe fixed income investments.  But your long term money should be invested in a diversified portfolio to provide long term growth for the 30 to 40 years you may spend in retirement.