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Do the math on pension payout

You’re 62 years old. You have a choice. You can either receive $30,000 every year for the rest of your life (and your life alone). Or you can have $375,000, once, right now.

Which would you choose?

This question is the basis for every pension decision that is ever made, by a new retiree. Should I take the monthly payment (pension), or more money than I’ve ever had at once (lump sum)?

No pressure, but if you mess up this decision, you’re going to regret it.

By the way, the numbers I just used are from a real-life situation.

If you were to take the lump sum of $375,000, then you would likely try your darnedest to recreate the annual $30,000 income stream that you passed up.

If you distributed $30,000 from the $375,000, you would be bleeding 8 percent off of the initial principle, regardless of investment return. A vast majority of financial experts agree that retirement distribution rates should stay around 4 percent or less. An 8 percent distribution, as just discussed, would be a recipe for disaster.

A Monte Carlo simulation of a portfolio made up of 60 percent stocks and 40 percent bonds suggests that an 8 percent distribution rate over a 25-year period has a 32 percent chance of success. In other words, you would have a 68 percent chance of running out of money. This risk is completely absorbed by you when you take the lump sum. When you take the pension payment, this risk is absorbed by the pension fund.

And it’s worth noting that the Pension Benefit Guaranty Corp. insures many private pension funds. In 2014, the PBGC insures up to $59,320 of pension income, per person, under a covered pension. Your pension, and in turn the PBGC, absorbs market risk and interest rate risk, when you stick with the pension. Why would you want that risk by taking the lump sum?

If you still insist on taking the lump sum, then you’d be wise to reduce your distribution rate greatly. Again, the distribution rate is how much money you remove from your investments, in relation to how much money you have invested. Don’t overthink it. Stick to 4 percent or less.

Looking at our $375,000 lump sum example, if you stick to 4 percent, then you will generate $15,000 per year. If you can’t live on $15,000 per year, then you will be forced to tap your other assets, such as your 401(k). Your retirement income stream is generally a combination of your pension (if you have one), Social Security payments and a distribution of your other investments and savings.

One of the primary arguments for taking the lump sum has always revolved around the health and reliability of the underlying pension fund. If the economy and market are struggling and the pension fails, then I’m “up a creek without a paddle.”

OK. But if the economy and market are struggling, what is happening with the lump sum that you invested? Most likely the same thing.

And yet another argument for taking the lump sum is the disappearance of the pension upon the retiree’s death. But this problem can easily be handled with life insurance, if the retiree is insurable (in good health). It’s a “get your cake and eat it, too” scenario when you pair life insurance with a pension. You get paid every month while you’re alive, and your survivor gets the lump sum when you die.