Do I withdraw from my retirement fund as a lump sum or in monthly payments?
Knowing on whether to take cash now or over time involves understanding the fund' math
Dubai: A lump sum pension is a one-time payment from your retirement plan. It provides a large sum of money, which you can use to fulfil your immediate retirement needs like; starting a new business or going on a world tour with your loved ones.
However, if you choose your retirement plan’s monthly lifetime payment option, that means you’ll get a benefit cheque every month for the rest of your life after you retire (like an annuity, which provides a reliable income stream in retirement in the form of a series of payments made at equal intervals).
Traditionally, this is how retirement pay-out plans, also called defined-benefit plans, usually work. The monthly benefit will always be the same amount each time. So if your monthly lifetime payment is Dh1,000, then you’ll get Dh1,000 each month like clockwork.
How do I decide between the two options?
Deciding whether a lump sum or a pension will turn out to be the better value for you personally is a complicated math problem with variables you can't predict like how long you'll live (and how long your spouse will live, if you're married), and the money you might earn by investing a lump sum.
If you question these assumptions, an online calculator can estimate the investment returns you would need on your lump sum to match the value of the the retirement fund. The best choice for you will depend completely on your individual circumstances.
Let’s take a look at some of what you need to consider before making this decision.
Let’s work out the retirement fund’s math and how it works
As you start to do your analysis, it can be helpful to compare the raw numbers. As an example, let’s say you’re trying to decide between a Dh300,000 lump sum or a lifetime income of Dh2,000 per month. This amounts to an annual return of 5.17 per cent if you live another 20 years.
In other words, if you were to take the lump sum and invest it on your own, you'd have to earn an average annual return of 5.17 per cent to equal income of Dh2,000 per month for 20 years. However, this isn’t quite an apples-to-apples comparison.
The lifetime income payments include a return of some of the original contributions along with investment returns. Additionally, it is guaranteeing you’ll receive the same amount of income if you live beyond 20 years.
The 5.17 per cent from investing the lump sum is a return on your money. Your actual investment results may wind up better or worse that this – with no guarantees.
Complicating the analysis is whether income from your retirement fund has a cost-of-living adjustment (COLA), which can increase your payments to help keep up with inflation.
This is a major factor because without a COLA you can lose considerable purchasing power over time.
Key factors to weigh when deciding between the two
• Your health and life expectancy are key
Let’s continue with the example above. If you take the lump sum, the longer you live beyond 20 years, the higher your annual return will need to be to match the lifetime income payments.
Conversely, the shorter your life, the more valuable the lump sum. Review your health and family history of longevity before you make your decision.
• Think about the impact on your loved ones
If you opt for lifetime income payments, you may have choices that would reduce your monthly payments but continue to pay lifetime income to your spouse or another survivor.
A lump sum, on the other hand, could provide more flexibility or benefits for other beneficiaries.
What other perks and risks do I consider when deciding?
A lump sum retirement fund distribution offers the flexibility of being able to spend or invest your retirement savings any way you see fit.
While a retirement fund annuity offers a fixed monthly income, a lump sum can be used to handle surprise medical expenses and can be passed on to one's beneficiaries in the event of early death. If invested carefully, it could also offer a passive income.
Perhaps the greatest risk of cashing out a retirement fund early is the prospect of running out of money. With life expectancies rising, many retirees face the increasing likelihood that they may outlive their savings, especially if they are not frugal.
Studies show that retirees who cash out their retirement funds are less likely to maintain the same levels of financial stability after five years. A monthly payment offers a steady income for the remainder of one's life, and in some cases can also be passed on to a spouse.
In effect, you've created the same sort of income stream that you would have had by choosing monthly pay outs from your retirement fund. The perk to this arrangement is that you get the security of a monthly check, plus a stash of money that can keep pace with inflation and help out with occasional unexpected costs.
Bottom line?
Most people choose a monthly pay out, also known as a ‘life annuity’. Having that steady income can make for less stress than taking a big lump sum, especially if you aren't an experienced investor.
If you take a lump sum, you must assume responsibility for how the money is invested and how much you can afford to spend each month.
One danger with a lump sum is that you may be tempted to spend too much today, leaving you short of money down the line.
By choosing a steady monthly pay out, you'll avoid the temptation to run through your retirement fund stash.