Many investors at some point in their lives face the decision of whether to take a lump sum payment or take a stream of income payments. This decision can involve a company pension plan at retirement, a private annuity that an investor is thinking about purchasing or even a judicial/lottery settlement. Regardless of the situation, it is important to critically analyze the pros and cons of all available options.
Frequently, lifetime versus lump sum payment decisions cannot be reversed once agreed upon and solidified.
Therefore, it is imperative to take all factors into account and make well-informed, wise decisions. Whether this is done independently or with the guidance of a financial advisor, doing a thorough analysis of all choices can be one the most important decisions in your financial life.
Below are just a sampling of the issues that can arise when considering payment schedule options.
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This is often the most important factor. By doing a discounted cash flow analysis, the implied rate of return is estimable by taking the income stream payments vs. the lump sum. Given average life expectancy, an investor would measure the "cost" of giving up the lump sum in year 1 and then add the positive cash flows for all the years thereafter until life expectancy is met. This calculation can be done with a calculator or through an excel spreadsheet. Often, regardless of the situation, the return is low (in the 2.5 percent - 4 percent range). The rates usually mimic longer term bond rates fairly closely. These low rates are why it is frequently appealing and justified to take the lump sum, all else equal.Taxes
Assuming the decision involves a pension plan and is a fully qualified account, the tax factor is not a major issue. The income payments are fully taxable at the federal level as would be the lump sum money once funds are removed from the IRA. If the pension plan is taken as a lump sum and is qualified, virtually without exception, you should roll the pension directly into an IRA.Flexibility/Availability Of Funds
This can be a major decision point. For investors with a relatively large liquid asset base/portfolio and little steady income outside of social security, having ready access to these funds might not be a large concern. In fact, for income diversification purposes, it might make sense for these types of investors to receive more steady reliable income vs. adding to their already large/liquid portfolios.However, for the majority of people having ready access to the money (a lump sum that can be accessed at any time) has value. Once the decision is made to take the payments, it is irreversible and the investor does not have access to the funds (save for the periodic payments) again.Longevity/Family History
Taking the lifetime income payments on a pension plan is essentially buying insurance against living a long time (well beyond life expectancy). The longer the life, the more money you make over your lifespan and the higher return you get on your decision. If your family has a history of longevity and if you are in very good health – all else equal – taking the annuity payments might be the way to go. Of course, on the other hand, if you have significant health issues, the lump sum may be a better choice!Benefit Structure (Joint, Single, etc.)
Depending on you and your spouse's exact financial situation, it might make sense to take the "single" option and get the higher lifetime payments on yourself. Alternatively, the joint option (which results in lower payments, but a continuation of the income stream for your spouse if something happened to you) could be the better choice. This depends on many factors that include the amount of liquid assets, life insurance, what other income is coming in and spending needs. Single investors usually would take the single payout option. Eric Mancini is the Director of Investment Research at Traphagen Financial Group, an independent investment advisory firm located in Northern New Jersey.© 2024 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.
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