Increasingly, employees with pension plans are being approached by current or former employers to trade their future monthly income for a lump-sum payment today.


Lower investment returns have left many pension plans woefully underfunded, enticing companies to find ways to reduce their obligations to future retirees. A recent change in how lump-sum payments must be calculated has also made offering these pension buyouts more attractive for employers.

While receiving a large lump-sum up front can appear attractive, this decision should be considered carefully. Once made, the choice is irreversible so it is important to understand both how the lump-sum is calculated and the repercussions of the decision on the retiree's long-range financial plan. Lump-sum payments can offer more flexibility, but the downside is the increased chance that the retiree outlives his or her assets.

When offering a pension buyout, companies must determine the present value of the future guaranteed income stream the retiree would receive if he or she opted for monthly payments. To be fair, the lump-sum payment should be equal to the future guaranteed income stream if the retiree has an average life expectancy. The calculation, however, does not take gender into account. Because women live longer than men, on average, the formula results in lower payments for women than they would be entitled to if their longer life expectancies were factored in.

In addition, companies are now allowed to use the corporate bond interest rates, rather than the lower rates on U.S. Treasury bonds, to determine the size of lump-sum payments. Discounting the stream of future monthly pension payments using higher interest rates results in a lump-sum payment that is smaller than it would have been under prior law.

Like most financial decisions, the right choice regarding a pension buyout will depend upon a retiree's unique financial circumstances. As a result, there is no set rule that can be applied.

From a tax perspective, there is no downside to taking the lump-sum payment. These payouts can be rolled over into a traditional IRA to avoid any immediate tax hit. Earnings on the plan balance will continue to grow tax deferred until withdrawals are taken during retirement.

Flexibility is often cited as a primary reason retirees elect lump-sum payments over guaranteed lifetime income. Once monthly payments are elected, the decision is irrevocable, meaning that monthly cash flow is limited. Instead, the retiree who takes a lump-sum payment can take larger or smaller withdrawals from his or her IRA as needed to manage expenses that will inevitably be uneven.

This flexibility also extends to how the funds are invested. Lump-sum payouts can be invested in any asset that is allowable under the rules governing IRAs. The question then is whether the retiree can earn a higher rate of return on the lump-sum than the company is providing through the pension plan. Higher rates of return, if realized, mean a larger income stream than the plan can provide. Earning this higher return, however, will require taking on risk. Because pension payments are guaranteed, these plans have a risk-free return built in. Retirees who are not comfortable investing their plan balances in riskier assets would likely be better off sticking with the plan's lifetime income payments. Investing a lump-sum payout in CDs or other guaranteed savings vehicles will not provide a return high enough to beat the pension plan's income payments.

Lump-sum payouts also mean that any unused amounts can be left to children or other beneficiaries. This flexibility is lost when monthly income payments are elected as this income stops when the retiree, or his or her spouse, dies. This is true even if very few payments have been received from the plan. Often, however, married retirees will find that the ability to provide a surviving spouse with an ongoing guaranteed income stream through the pension overrides the desire to leave a legacy for children.

Ultimately, the decision to forgo guaranteed income hinges on the retiree's life expectancy, the expectation of higher investment returns, and the availability of other resources that can be utilized to meet retirement living expenses. These factors are best evaluated as part of an overall financial plan, which can provide the context needed to make this important choice.

David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Agent at Mackensen & Company Inc., a fee-only advisory firm in Hampton. He can be reached at 926-1775, or by visiting