When I was in sixth grade, a classmate’s grandma won a million dollars in the lottery. This made the front page of our small town’s weekly paper. Even as a 12-year-old I knew that buying lottery tickets wasn’t a smart investment strategy, but one detail of the story that didn’t make sense was why the lady chose to take a lump-sum payment instead of the annual payments for 20 years. The math was simple: She would have received more had she just been more patient. Or so my know-it-all preteen self thought.
Looking at the situation now, this retiree was quite smart; taking a lump sum rather than many smaller payments meant two things: All of the money was in her hands right away, and she could invest it to earn even more money. There’s no guarantee that she’d live long enough to collect all of the money, and while she could invest each installment, investing a larger amount right away meant she could put the power of compound interest to work right away.
When faced with the decision to take a one-time payout or spread it out over several years, you need to consider these two things. Let’s take a closer look to see why taking the potentially smaller payout makes sense for most people.
The Money Survives You
With many pensions and severance packages, once you pass away, the checks stop coming. This leaves your surviving partner and dependents, if any, without any income. That could be problematic if they’re relying on this monthly income. Even if you’re not leaving anyone behind, if you pass early, you may not collect as much money as you would have received had you taken the lump sum.
In the case of a pension, this is money that you’ve traded your time, energy, and expertise for; it’s a form of delayed compensation. Finally, even if you have a healthy 401(k) and Roth IRA, why leave money sitting on the table? By taking it all at once, it’s yours to use how you like. Use it to pay off debt, donate some to a favorite charity, and invest it to grow your estate.
You Can Invest and Grow the Money
This is the controversial part of taking a lump-sum payment. Your money might go up and it might go down. But if you take the set-it-and-forget-it approach, there will be a nice mix of ups and downs, hopefully more of the former, and you’ll have gained extra cash in the process.
Let’s say 35-year-old Sally has the option of taking a severance package that gives her $15,000 right now or $700 a month starting at age 65. We’ll calculate the rate of return at a conservative 6%.
Lump-sum option: Sally invests the money in an index fund that earns 6% each year. The year that she turns 65 the fund has $86,152.37. This is when her peers can start taking their lump sum payments. Let’s say she enjoys another 20 years of life, which puts her at 85. At that time her account contains $276,302.35.
Monthly payment option: Sally has a job and figures she will need the money later more than right now. Plus if she lives until age 85, she’ll receive a total of $168,000 in payments — compared to the lump sum, this seems to be the better option. The numbers get even better if she invests each $700 check: At age 85, she’d have $327, 538.88.
This scenario looks like the clear winner until you go back to what we discussed earlier: Our days are not guaranteed. Sally could get a terminal illness in her 40s, which leaves her survivors with nothing; she could pass away of natural causes at age 67, after having received just $16,000.
What’s the Answer?
Unfortunately, I don’t have a crystal ball to give you an answer to your situation. But I think if you’re reading this, you probably care about your financial situation, and are always striving to improve it. If you’re that type of person, you’d likely benefit by taking the lump sum. That’s what I’ll do if I ever find myself in such a situation.