If you’re fortunate enough to have a pension from one of your employers, you’ll generally have two options for getting the money: as an annuity, meaning you’ll get a regular payment each month for the rest of your life; or as a lump-sum payout, meaning you get a large wad of cash immediately. A recent MetLife survey found that choosing the latter option is usually a horrible mistake.
The dangers of lump-sum payouts
The problem with suddenly getting your hands on a large sum of money is that the temptation to spend more of it than you should is intense. The MetLife survey found that one in five of the people who took lump-sum payouts spent it within a few years; on average, the money lasted about 5 1/2 years. Given that most retirements will last for 20 to 30 years, spending your entire pension in less than six years is clearly going to lead to disaster. Many of the survey respondents who took lump-sum payouts said that they regretted how much of the money they spent during the first year and how they spent it. On the other hand, 96% of those who chose the annuity option are happy with their decision.
Turning a lump-sum into an annuity
If you’ve taken a lump-sum payout but are having serious second thoughts, one option is to take that money and use it to buy an annuity. This can also be an option if you aren’t happy with the annuity offered by your pension and find a more suitable option somewhere else. Most retirees will be happiest with a fixed annuity, which is similar to the annuity offered by most pensions: a set, guaranteed payment each month for the rest of your life. Some of these annuities are inflation protected, meaning that the money you get will rise with inflation. However, the more complicated the annuity is, the higher the fees you’ll likely pay — so make sure you understand exactly what all those bells and whistles cost.
Other options for managing lump sums
If you’re a disciplined, experienced investor, you may feel that a lump-sum payout is the better option for you because you can get a better return investing those funds than you’d get from the annuity. You may well be right about that, but it’s wise to take some precautions to avoid the most common lump-sum issues. First, put the money someplace where you won’t be tempted to spend it right away. One option is to dump part of it into an index fund or ETF, preferably an S&P 500 fund, and the rest into treasury securities.
You can use the retirement savings allocation formula of 110 minus your age to figure out how much should go into stocks and how much into bonds. Subtract your age from 110, and whatever the result is should be the percent of your portfolio that goes into stocks. What ever is left over goes into bonds. By investing the money promptly, you’ll be less tempted to treat it as a source of ready cash.
Second, keep most if not all of your lump-sum in fairly conservative investments. The bulk of the stock portion should remain in the aforementioned index fund; bonds should be high-quality issues only; and limit experimental investments, such as commodities and individual stocks, to no more than 5% or so of the entire sum. These steps will help to preserve your lump-sum — and keep it producing good returns — throughout your retirement.
So when do I get to spend it?
Think of your lump-sum as seed money. While it’s sitting in your investment accounts, it’s growing and producing more money for you. As it grows, you can take some of it out and spend it, but if you take too much too early you’ll stunt its growth permanently. The safest approach is to treat your lump-sum the same way that you treat your 401(k) and IRA accounts — limit your annual distributions to from 3% to 3 1/2% during your first few years of retirement, increasing that percentage gradually as you get older. Sticking to a conservative distribution rate will practically guarantee that your money will be there as long as you need it.
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