The Nuts and Bolts of Choosing a Lump Sum

By John Iekel • May 19, 2017 • 0 Comments

Choosing between a lump sum and regular, smaller payments over a long period is only the beginning. There are many other moving parts to the process, and many important considerations.

An Informed Choice?

MetLife in “Paycheck or Pot of Gold Study: Making Workplace Retirement Savings Last,” Showed results that were mixed at best regarding how well-informed those who chose lump sums were before they made their decision.

A majority of DB and DC plan participants who could choose between a lump sum and annuity payments did receive some kind of information to help them make the decision. Approximately 30% of those who chose to receive a lump sum received a projection estimating how long their funds would last. But providing such information is not a legal requirement for an employer or a plan, so if a participant receives it that may be at least in part due to their largesse.

Further, MetLife’s study indicates that “not required” may translate to “not done” as far as informing participants about the risk of outliving their retirement savings is concerned. The study says that 31% of DB plan participants and 23% of DC plan participants who were given a choice between a lump sum or an annuity received such information. Not only that, that just over one-quarter of participants of both kinds of plans were shown information about coordinating their pension benefits or DC plan balances with other retirement income streams.

Roses Have Thorns

Choosing a lump sum also means accepting certain risks.

Perhaps the most significant is retirement funds running out during the retirement years. The MetLife study says, “While taking a retirement distribution entirely as a lump sum may make sense for some individuals, this study has highlighted that many individuals who take lump sums from their workplace retirement plans have depleted their money too quickly relative to their life expectancy” and that even those who had some money left are in danger of running out of money during retirement.

But just because it’s serious doesn’t mean a participant automatically receives information about that possibility. MetLife found that 12% of DB plan participants and 20% of DC plan participants received information about that risk.

The results? Just over 20% of those who took a lump sum ran out of money in an average of 5.5 years, and those who took money from their DC plans and had no DB plan income depleted their retirement funds even faster.

Funds insufficient for the entirely of one’s retirement are not owing only to overspending a lump sum, however; they also can result if the retiree fails to invest the funds for sufficient growth. “Of course, the longer the retiree is expected to live, the greater the number of anticipated pension payments, and the greater the portfolio hurdle rate will be,” observes Michael Kitces in his “Nerd’s Eye View” blog. “Ultimately, though, whether it is really a ‘risk’ to outlive the guaranteed lifetime payments that the pension offers by taking a lump sum depends on what kind of return must be generated on that lump sum to replicate the payments,” says Kitces.

It’s wise to keep the effect of a stock market drop in mind as well, Aaron Pottichen, President, Retirement Services at CLS Partners, suggests, observing that “the impact of a taking a lump sum and having the market drop is substantially more impactful to an individual (or couple) that is older, than it is to a young person that has time to recoup those loses.”

And the Department of Labor’s fiduciary rule is another consideration. Pension Resource Center Chief Executive Officer Jason Roberts characterizes it as “the elephant in the room” and says he “can’t ignore” it in the consideration of whether a participant should seek a lump sum payment.

Roberts says that the advent of the rule makes it even more important that the retirement plan give a participant and idea of projected income and expenses when one is considering whether to take a lump sum.

What to Do?

MetLife suggests that individuals “consider their need for both income and some level of liquidity, as well as their investment skills, and how these may change as they get older and experience potential declines in cognition.”

The Pension Rights Center offers some ideas on considerations to take into account when deciding whether to take a lump sum distribution:

  • Could my spouse or I have a lifespan longer than the average life expectancy?

  • Can I afford to lose some — or all — of the money?

  • How good are my spouse and I at investing?

MetLife also suggests that employers “have an important role” regarding designing retirement plans to help make sure that employees easily understand lifetime income and that they can access it directly from the plan and that “a plan design providing only for a lump sum distribution may increasingly seem to be at cross-purposes with that objective.”

Pottichen argues for careful consideration. “If you are younger, consider taking a lump-sum, but only if you believe you can manage that money (and your emotions) in such a way to accumulate more assets than the annuity would have paid you. If you are older, consider the risk of taking a lump-sum and having those assets drop by decent amount and what impact that would have on your ability to live. If the ability to control how those assets are invested is worth that, than consider taking the annuity. If not, than taking the annuity might be the better option.”

Some participants take matters in their own hands, MetLife says: around 80% in both kinds of plans conducted their own research or consulted with someone when they were deciding whether to take a lump sum payment, receive annuity payments or decide what to do with a DC plan balance.

But personal initiative was not universal. MetLife says that just under half of those who took a lump sum consulted first with a financial planner, and even fewer of those who opted for an annuity did so. And just 6% of those with participated only in a DC plan conducted online research before deciding what to do with their balances.

Roberts stresses the importance of turning to a financial professional, since in his view “most individuals are pretty much incapable” of understanding all the factors involved in deciding whether to take a lump sum payment. Participants “need to be well-informed and well-advised,” he says.

Pottichen argues “each individual’s situation is different and there are so many factors that can influence which is better for someone” regarding whether it is better to take a lump sum rather than an annuity. And that, he says, “is why a financial plan is so important.”

“The best way for any individual or couple to know what the right answer is, is to have a financial plan,” argues Pottichen. He adds, “Doctors don’t prescribe medicine based off of statistics, they prescribe based off of a person’s health history and many other factors. The same should go for individuals or couples, they shouldn’t make financial decisions based off of generalities. They should work with a fiduciary advisor and make informed decisions that are based on facts, history and many other factors that lead to a financial plan.”