Imagine this scenario. You are offered the opportunity to take a one-time lump sum payout or an annual payment for the rest of your life. Which option should you choose?
That's a scenario that may play out several times during your life. Sometimes it will be an employer who offers that deal with the company's retirement plan. If you're lucky, it may be a state lottery commission.
If you're like 70% of Americans who were offered that choice for their employer's pension plan in recent years, you will likely choose the lump sum cash offer. But is that the best choice? How can you find out?
If you want to boil it down to a single number without taking other considerations into account, you could base your decision on a figure called the pension income ratio. Simply take the amount of the annual payout you have been offered and divide it by the amount of the lump sum payout you've been offered as an alternative.
Let's do that math with an example in the following tool. If you're reading this article on a site that republishes our RSS news feed, you may need to click through to our site to access a working version of it.
Now, think about what kind of annual rate of return you could reliably get from investing the lump sum payout. If your result from the tool above is higher than that rate, you might be better off choosing the annual income payout over the lump sum.
Most financial planners will use a rate of return of 6.0% as the rule-of-thumb threshold for choosing which option is better, but a more conservative approach would be to use a lower figure.
For the default numbers in the tool, the result of 6.7% is higher than the 6.0% threshold, which would suggest the better option is to go with the annual income payments. Most financial planners would agree that rate of return would be difficult to average over a long period of time.
But what if the offer for the annual income payments was lower? What if it was $35,000 instead?
That figure would drop the pension income ratio down to 4.7%, where taking the lump sum would become more attractive.
There are other factors that can affect the decision of which choice is better (such as your age, health, etc.) but the idea here is to use the pension income ratio as a starting point for those additional considerations.
For more discussion, check out Michael Aloi's recent article on how a math formula drives one retiree’s choice and Wes Moss' article on the question of whether you should take a lump sum payout or a pension. And of course, our own 2015 article on whether you should take a pension buyout, which was a very topical question that year!
Image credit: Photo by Pepi Stojanovski on Unsplash