facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog search brokercheck brokercheck Play Pause
Does Your Monthly Pension Offer Pass the 7% Test? Thumbnail

Does Your Monthly Pension Offer Pass the 7% Test?

Today I would like to discuss one of the biggest decisions some of you have to make when you retire. Should I take my company's monthly pension offer or should I take the lump sum offer? I said some of you because, depending on your employer, you might only receive a monthly pension offer. However, some of you will get to choose between the two. Let's take a look at the options.

Does Your Monthly Pension Offer Pass the 7% Test?

If your monthly pension offer from your employer is 7% or more of the lump sum then it may be worth considering.  If it’s below 7%, then you can likely do just as well (or better) by taking the lump sum and working with a financial adviser to invest the money strategically, and then paying yourself a salary from the lump sum amount (a form of your own personal pension that you control).


Here’s how the math works:

Take your monthly pension offer and multiply it by 12, then divide by the lump sum offer.

Example 1:  $1,000 a month for life beginning at age 65 or $160,000 lump sum today?  $1,000 x 12 = $12,000 divided by $160,000 equals = 7.5%. 

In this case, you would have to make approximately 7.5% per year on the $160,000 to earn a steady $12,000 a year.  Earning 7.5% a year consistently and forever is a doable, but tall task, so taking the monthly amount here (7.5% is greater than 7%), tells me that the monthly amount could be a better deal long term.

***Keep in mind, part of what a pension is doing is technically just paying you back your own money.  On your own, you can withdraw 5% per year from any lump sum (even if the funds are earning 0%), and the money should last for 20 years (5% x 20 years = 100% withdrawal). However, the funds will be earning interest, so if the funds earn 5% on average and you withdraw 5% you will never touch the principal amount.

Twenty years is a long time…especially when you may not begin a pension until age 65. Twenty years will get you to age 85 using 5% each year in an environment where you make a zero percent return.  My point in bringing up this math is that any monthly pension you elect to take over a lump sum amount should be well north of a 5% annual return/payment (that’s why I set my rule of thumb at 7%).

Example 2:  $708 a month for life or a $170,000 lump sum today?  $708 x 12 = $8,496 divided by $170,000 equals a 5% payout.  In this case, the monthly pension amount is offering you a return (for life) of about 5%. Remember, for the first 20 years earning zero, you could do the same before you run out.  All you have to do is make a very modest return (call it 2% per year), and you would be forever ahead of what the company’s monthly pension would do for you.  In this case 5% is less than my bare minimum benchmark of 7%, so you would likely be better off taking the lump sum of $170,000.

Other Factors to Consider

  1. Your age to begin a monthly pension vs. the lump sum.
  2. Your projected longevity. The longer you live the more valuable the monthly pension amount will likely be worth to you.
  3. The type of pension payout option you elect. Is it based just on your life and then stops after you die, or does it continue for your spouse’s life as well? Is there a “period certain” option that would be paid to your beneficiaries for a set number of years even if you pass away soon after taking the monthly pension? 
  4. The solvency of the company “promising you the pension” for 20 plus years, and does the Pension Benefit Guaranty Corporation (PBGC) back up your payments if your former company paying the pension goes out of business? 
  5. Will you at some point need a “lump sum” amount of money for an emergency or a retirement want?  Maybe you already have that covered with other accounts or resources, so think of the lump sum offer in the context of other assets on hand.

There are numerous reasons to take the pension or the lump sum amount and every individual will have different needs and wants in retirement. There is no one size fits all in retirement. Each case will be unique.

There’s a lot to consider when it comes to the lump sum vs. pension question.  The first step is to do the math, and see if the monthly pension amount at least passes the “7% test.”  Then beyond the 7% test consider how the other variables (above) tip the scales towards a monthly amount or a lump sum.

***For those wondering the reason I use 7% it's because stocks/equity investments have historically yielded 10% per year. Inflation has averaged 3% a year. 10-3=7. That's where I get the 7% from. No, you won't ever get 7% every single year but over a 20 year retirement 7% is a fairly safe bet.

Final Thoughts

As humans, we worry about many decisions in our lives, but almost of all the decisions we worry about can be undone. Meaning even if we choose wrong, we can fix it later. When choosing between a monthly pension and lump sum offer this is NOT the case. You can't change your mind later. You can't undo the decision.

At 80/20 Financial Services, we believe you should be in control of your money and not the company you worked for. In our experience, there are very few instances where taking the monthly pension annuity makes sense. With the lump sum amount you have control, flexibility, options and security. You have control of your money and can make your own salary, you have flexibility in case of emergency or other financial needs, you have the option to leave a legacy to your heirs or to your favorite charity, you have security knowing that all of your money is in YOUR Individual retirement Account (IRA).

This is possibly the biggest financial decision of your retirement future and there aren't any do overs. You don't have to make this decision alone. At 80/20 Financial Services our mission is simple:

"In a partnership with each client, we create a personalized retirement plan and spending strategy to ensure your money will last as long as you want it to."

For more articles about retirement planning and investing click here.

Thanks for reading!

Brian Coleman/Retirement Planner/Investment Manager

80/20 Financial Services is an independent Registered Investment Advisory Firm. Our focus is working with retirees, and we specialize in working with retirees who are approaching or going through the retirement transition. We are located in Ozark, MO but we have the ability to work with clients throughout the United States. Contact us today for help with your retirement needs.