Lump sum or monthly payment? How to make the right choice for your pension

Rocking chair on deck overlooking water

Retirement is on the horizon, and you have amassed a hefty sum of money in your pension plan. Now comes the big question: Do you take a lump-sum payment or a monthly distribution?

While the knee-jerk reaction is to take the money and run, especially if you are looking at a check for several hundred thousand dollars or more, there are several factors you should consider before you decide.

Here’s a step-by-step guide to making a smart choice.

Step 1. Do the math. How much monthly income will a lump sum provide over the next 20, 25, 30 years? (See the Interest.com story on the 4% rule.) How long would it take for your total monthly income to surpass the lump sum? Remember the monthly payments are for life, so if you are in good health and anticipate being around for another 30 or 35 years, you could benefit from taking monthly payouts.

Step 2. What are your plans? Are you thinking of starting a business? Traveling around the world? A large sum of money can allow you to do some of the things on your bucket list. Taking more now and pushing back your Social Security is one way to balance things out a little bit. But, if you have more modest plans and your monthly pension checks will cover your lifestyle needs, you may opt for the simplicity of ongoing payments.

Step 3. How well do you manage money? Be honest, if someone hands you a check for $800,000, will half of it be gone in three years? The advantage of a monthly check is that someone else manages your money for you. The disadvantage is that you have less liquidity, but for some people that is a good thing.

Step 4. How well can you invest the money? Before you take a lump-sum payout, you need to know where you’d put it. That’s a particularly tough decision to make right now. CDs are a safe choice, but interest rates are pathetically low. Most retirees aren’t comfortable with the stock market’s extraordinary volatility over the past decade. And don’t forget the old rule of thumb: Subtract your age from 100, and that’s the maximum percentage of your savings you should have in stocks. So if you’re 65, you shouldn’t invest more than 35% of a lump-sum payout in stocks, no matter what.

Step 5. Consider inflation. While inflation has been very low in recent years, it's a factor to consider. Are your monthly payments adjusted for inflation? If not, you could do better with a lump sum, but again, you’ll need to beat a typical 3% annual inflation rate.

“It’s a personal decision depending on the financial needs of the person, according to David Abuaf, CFA and chief investment officer of Hefty Wealth Partners in Auburn, Ind.

While Abuaf says he’s seen more people taking a lump sum in recent years because their net worth declined during the recession, he wouldn’t be surprised to see more people who are concerned about the long term start taking the non-lump-sum payments.