Pension Lump Sum Rollover: Advantages And Disadvantages

Accountancy Resources

Pension Lump Sum Rollover: Advantages And Disadvantages


During the early post-World War II days, employers implemented defined benefit pension plans to provide retirement income to the workers who were loyal enough to the company to spend their careers there. This was the way of life for many American workers, and many employees spent an entire career with one company. Saving for retirement was not an issue for some workers. It wasn’t until decades later that the true cost of maintaining these plans was discovered by the companies providing them.

Defined Benefit pension plans have been the catalyst in many corporate bankruptcies over the years as the liabilities under the plans swelled to unsustainable levels. As a result, the companies still providing pension plans have been forced to make difficult decisions regarding the payment of retirement income to employees who are near retirement or already retired. As Defined Benefit pension plans continue their slow fade into extinction, the few individuals still covered under these plans are now being faced with some difficult decisions.

Some companies have been able to unload all or a portion of their pension liability onto insurance and annuity companies, allowing the insurance companies to take over the plan in exchange for providing a guaranteed income to the existing plan participants. Other companies have been forced to reduce benefits or offer employees a smaller lump sum payment instead of lifetime payments which were customary under most original pension plans. Many employees are now faced with deciding between a lifetime payment and a lump sum payment and are often not given much time to weigh the options carefully and make an informed decision. Taking a lump sum vs. a lifetime payout has its advantages and disadvantages.

Advantages of the Lump Sum Pension Rollover

A lump-sum pension rollover allows the employee to take control of the investment options for that lump sum. The individual will be able to make decisions on how to invest that money or hire a financial advisor or investment manager to assist with the process. The employee will also have full control of and access to any or all of the money in the account as needed, unlike the lifetime income payment where they only receive a set payment each month. Further, if the individual dies, his or her spouse, children, or other heirs will have access to any money left in the account. The individual will pay taxes on the money only when she withdraws it from the account, so investments in the account will continue to grow tax-deferred. It is possible that the investments chosen may perform well, providing higher income than otherwise may have been available under a lifetime payment from the pension. These benefits of taking a lump sum rollover must be weighed against the benefits of taking a set income.

Lifetime Income

When a lump sum rollover is not taken, the only option available is to take a predetermined amount of income. This can usually be payable over the life of the individual, for a specific number of years, or until the second to die of a married couple. The investment risk is borne by the company or by an insurance contract, so payments to the individual are guaranteed and backed to some extent by the Pension Benefit Guaranty Corporation. If the individual has chosen to take the payments over his or her own lifetime and dies before the spouse, the spouse will not continue receiving any payments. A joint life payment must be chosen in order to avoid this. Like the lump sum rollover, payments are taxable as ordinary income only when they are received.

Comparing the Lifetime Income Option vs. the Lump Sum Rollover

While the lump sum rollover has advantages and disadvantages, the only way to make the most informed decision is to look at the payments over a lifetime versus the amount available in a lump sum. In order to determine the true benefit of each, it is important to do a simple calculation to compare the options. By dividing the total annual income from an income payout by the total lump sum available for rollover, it is easy to see what the “spend rate” would have to be on the lump sum to equal the lifetime payments. Let’s say you have the option to take a $100,000 lump sum or $600 per month for life. $600 per month is $7,200 per year. So if we divide the annual income of $7,200 by the $100,000 lump sum available for rollover, that means we would have to take 7.2% of the total lump sum rollover value each year to equal the monthly payments available under the guaranteed income option.

Depending on the age when these payments begin and the life expectancy of the individual, the lifetime payment amount will vary. The older the individual is, the higher the annual income will be from the lifetime payment. Younger individuals are likely better off taking the lump sum and investing it for the long run, whereas, older individuals may be better off with the income for life.