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During your working career but especially at retirement, you might be offered a deal where you must decide whether to take a lump sum or a series of payments stretched over time. Which is better? For answers, we turn to senior financial planners with the Planning Center—Matthew Sivertsen in Moline, Ill., and Cicily Maton in Chicago:
Larry Light: I understand you are often asked whether to take a lump sum of money, or choose instead a series of payments in the future. What do you tell the clients facing such a choice?
Matthew Sivertsen: Admittedly, having to decide how to receive a windfall in any form is a great problem to have. The key to helping our clients decide which option might be best for them is to have a really good handle on every component of their finances. It also helps to understand their general sentiments about, and behavior profile around, money.
Cicily Maton: The first step is to review our clients’ cash flow and expenses. Do they have too much or too little monthly income? How well do they manage it? The second step is to evaluate their balance sheet and calculate the value of their assets minus their liabilities. Do they have strong or weak asset positions? Are their debts manageable?
The third step is to look at the big picture and take into account other factors like familial considerations. Do they have loved ones who are dependent on this plan? Are there estate objectives dedicated to their children or others?
Light: Give me some real-world examples of how this plays out.
Sivertsen: OK. A couple in their 60s, both employed by government agencies, has assets of $1 million in an IRA, plus a home they own. An analysis by an advisor determines that they would be better off financially, by a very small margin, with taking a lump sum payment. There was risk involved since the stability of the state government agency to be able to maintain a payments over time, without some financial adjustment, was very problematic.
Nonetheless, their decision was to take the future payments, fully aware of the risk that if payments from the government were cut in the future they would have the IRA to rely on for their welfare.
Maton: Another couple, both 65, are employed at different corporations, held assets of $600,000 plus two homes, one of which was about to be sold. Their decision was to take the lump sum, as the couple had little confidence that the corporations would not adjust payouts in the future if economic conditions took a turn for the worse. They were comfortable with their decision even though a financial analysis indicated that the payments over time would be somewhat more advantageous.
Light: What are the pluses and minuses of a lump sum?
Sivertsen: I’ll take the pros. First, with a lump sum, you maintain control of the money, with the freedom to invest in a financial portfolio that is tailored to your personal circumstances. Also, it is an asset on your balance sheet, and you have control over how to distribute the money upon your death.
In addition, you do not have to worry about the stability of the underlying company or government agency or insurance company to pay out obligations over a long period. If proceeds are invested in a portfolio, growth may be taxed at lower capital gain rates.
Maton: Chief among the cons of lump sum payments are that you assume market risk. If you take on too much risk, the market could suffer a downturn in the early years of retirement, jeopardizing the ability of your portfolio to maintain its value over the long term and increasing the possibility you will run out of money.
Along with that, there may be the tendency for you to overspend, drawing out more money than the portfolio can generate over time. If investments are too conservative, returns may not be high enough to generate the money needed to sustain your standard of living.
Light: What about the good and bad of receiving payments over time?
Sivertsen: Here, the pros are that there is the discipline of stable periodic payments, helping you to control overspending. There are no worries about investment decisions. And you have an ability to use other assets to meet specific goals.
Maton: The cons of the payments method include that you have no control of investments. And what if your former employer or an insurer is unable to meet their obligations or change the policy affecting payout benefits.
Meanwhile, you have a limited choice of beneficiaries. Then you have a limited or no opportunity to get additional money in an emergency. Beyond that, your distributions are taxed at ordinary income tax rates, which may rise higher.
Deciding which way to go is no easy decision. It requires careful consideration of your life goals and objectives. Your money management habits—good or bad—may also factor into the decision that is ultimately made.