When companies a pensionit is common to give retirees two options: receive the pension as a lifetime monthly payment or receive it as a lump sum upon retirement.

Monthly payments over time are the form most people associate with pensions. However, sometimes a lump sum payment can be a better option. Depending on what your business has to offer and what kind of returns you can aim for, you may be able to get more for your money in the long run by raising everything up front.

For example, suppose you are an individual getting ready for retirement. Your employer has offered you a lump sum of $150,000 or $1,200 monthly payments for life. Here's how to think about it.

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How do pensions work?

Pensions are also called 'fixed pension schemes'. This means that your employer is committed to providing certain benefits upon retirement. This is in contrast to 'defined contribution pension schemes', where your employer undertakes to make certain contributions during employment.

With a pension, your employer promises to provide you with a monthly benefit during your retirement. The exact amount can vary widely and is generally determined by factors such as your age, salary history, tenure with the company and seniority at retirement. This quantity It can be indexed to inflation or, like an annuity, it can be fixed.

It is the employer's responsibility to keep the pension funded and solvent for the lifetime of eligible former employees. Pensions are needed to ensure that this system functions tucked back by a federal agency that insures pensions up to a certain maximum amount.

Managing the costs of pensions

Pensions are popular among employees and retirees because of their reliability. You don't have to worry about the balance between savings and living expenses. You also don't have to deal with complex, unpredictable and (if you do it alone, terribly mixed) market returns. Instead, you can simply retire with an income.

However, for the same reason, pensions have become unpopular among employers. The same reliability that makes pensions valuable to retirees leads to high and indefinite costs for companies. The cost of caring for former employees is simply very expensive.

As a result, it is common among employers who do offer a pension to 'lump sum benefitsWith a lump sum benefit, the employee receives a one-time payment upon retirement instead of monthly payments for life. This allows an indefinite series of payments to be converted into one, planned expense, which is much more manageable for the employer.

Should you take a lump sum or monthly payments?

But what is best for you as an employee?

For example, suppose your employer has offered you two options. You can receive $1,200 per month for the rest of your life, or you can receive a lump sum of $150,000. Which one should you take?

The answer here depends on many factors, including how the math works.

Reliability

If you are looking for reliability, take the monthly payment. As discussed below, under the right circumstances you could get more money from the lump sum payment, but that will depend on market returns and there is an element of risk associated with any investment. If you take the monthly pension, your payments will be largely secure and your budgeting and investing needs may be simpler.

Total income

If you are instead trying to maximize your retirement income, the right choice will depend greatly on your assumptions and your expected investment results.

An investor looking for safer investments, usually in the bond market, will likely make more money making the monthly payments. An investor who can successfully manage a more aggressive position, for example with a balanced portfolio or an S&P 500 index fund, will likely earn more from the lump sum.

To understand this, let's assume you retire at age 67 and are of retirement age average life expectancy of around 85 years. And let's assume that your pension is fixed, without inflation corrections. With the help of Schwabs pension calculator, you would have to invest your $150,000 at a 7.03% return just to match the income from your $1200 monthly payments over your life expectancy.

This means that you need a reliable return of around 8% to make the lump sum meaningfully more valuable than the monthly payments and still be able to use some of it in the meantime. This is certainly possible. In fact, 8% roughly corresponds to the average return on a mixed bond/equity portfolio. And if you have the flexibility to manage volatility, you can do even better with the 10% to 11% average return of a pure S&P 500 fund.

But it would mean managing the volatility and risk associated with equity investing. In particular, you need an income plan during the bad years so that sequence risk does not erode the value of your portfolio. For this reason, retirees prefer to shift their investments toward security during retirement. This tends to lean towards bond-heavy portfolios, which generally deliver returns between 4% and 6%. In that case, the $1,200 monthly payment would likely provide both better security and more income.

a fiduciary financial advisor can help you perform the calculations in your personal situation. Make sure there is a match with up to three advisors for free.

Inflation

A silent headline here is inflation, as it can cut both ways.

Many pensions are partly indexed inflation, known as a “cost-of-living adjustment.” They may use the same process as Social Securitymaking an actual inflation adjustment each year, or they can simply increase payments by a fixed percentage.

In this case, with a starting payment of €1200 per month, we assume that your employer has a simple reference inflation index. They increase your pension by 2% every year to keep it in line with the Federal Reserve's target rate.

In that case again based on Schwab's calculator, you would need to invest your $150,000 with a return of at least 9.03% to generate the same income as your monthly pension. You would need a reliable 10% return to significantly beat the $1,200 indexed payment.

Now this is possible again. Ten percent is approximately The average annual return of the S&P 500. However, you should keep your money entirely in stocks, which means managing the volatility of market dips and storms.

This is fine during your working life, if you can just leave that money alone to ride out a bear market. (That's exactly what you should do. Ignore all the very bad financial advice that suggests you “lost” money from your 401(k) during a recession.) When you retire, it's a different story. Because managing sequence risk is much more difficult if you rely on this money for your income, most households would generally gain more money and security by taking the $1,200 per month.

On the other hand, suppose your monthly pension has no inflation index. You will then receive a fixed amount of € 1,200 per month. This exposes your income to inflation risk in a way that taking the lump sum does not. With the lump sum you are more likely to receive inflation-indexed growth. This will help protect your household from escalating costs, although again this comes at the cost of the need for quite significant returns to keep up with lost retirement income.

A financial advisor can help you understand the consequences of your employer's specific pension plan. Talk to a financial advisor today.

It comes down to

If your employer offers a pension, they often give you two options: a monthly payment for life or a lump sum upon retirement. Seek good financial advice when choosing between these two options, as the right answer will depend greatly on your investment approach and your personal situation.