Retirement has changed considerably over the last thirty years. People are living longer, and retirees face greater challenges funding their retirement spending. Years ago, many people were able to rely on a pension along with Social Security income to fund most of their living expenses. However, many companies have been eliminating pensions over the last thirty years, which has shifted more of the responsibility to save for retirement to individuals. If you are one of the fortunate ones who still has a pension benefit, you may face the dilemma of how to receive your benefit—should you elect a monthly annuity payment for the rest of your life, or should you request a lump sum payout? The “best” answer depends on your own unique circumstances. In this blog, I share what you should consider in making that decision.
As you approach retirement, there are many things to consider.
- How much do you plan to spend on basic living expenses, on healthcare costs, and on discretionary items?
- How much in guaranteed income and retirement assets do you have to fund your retirement spending?
- How much can you expect to earn on your investment assets?
- How long do you and your spouse expect to live?
- How much risk are you willing to take?
These questions address the critical elements of your retirement plan. Answering them and understanding the implications for your retirement will enable you to make a more informed decision on how to take your pension benefit.
In evaluating your pension, a first step is to understand how good the annuity option is. Prior to retiring, your employer will provide you the amount of both the monthly annuity payment and the lump sum.
For the lump sum amount, determine the best annuity you could purchase from a private insurer and compare it to the pension annuity benefit. Recent changes in calculating pension annuities for a given lump sum have made it more likely that the pension annuity will be a larger benefit than a purchased annuity. If you don’t find a better commercial annuity, your first consideration would be in favor of accepting the pension annuity option.
Assuming the pension annuity is a favorable option, it is still worthwhile to consider taking the lump sum benefit. Estimate your rate of investment return if you were to invest the lump sum amount. Will you be able to earn a higher return than is assumed by the pension plan’s annuity? If so, investing the lump sum may allow you to increase your benefit and protect your spending given the risk of inflation. However, be aware that the deciding to invest with the calculation that you can earn a higher return transfers an added risk to you.
Let’s consider some other trade-offs in accepting a monthly annuity versus a lump sum payout. First, the lump sum option allows you to take control of your benefit. You will have the flexibility to spend a larger portion of the benefit if the need arises. You can rollover the lump sum to an IRA and designate beneficiaries. Additionally, taking a lump sum eliminates the risk of losing a portion of the benefit should you pass away early, as annuity payments may stop upon your death.
Conversely, by opting for the annuity you transfer the risks of low investment returns or of living beyond your life expectancy from you to the pension plan. The annuity provides a monthly income in addition to your Social Security income. Having more guaranteed income that covers a large portion of your living expenses can create more security. As a word of caution, however: when considering an annuity, be sure to check the financial stability of the employer. While the Pension Benefit Guaranty Corporation, a federal agency, provides insurance for pension participants, the protection is not unlimited should the pension fund encounter financial difficulties.
If you decide to accept an annuity from the pension plan, you’ll likely have another decision to make. Most pension plans offer you several annuity types.
- A single life annuity makes payments to you for life, but payments end when you pass away.
- Joint and survivor annuity makes payments to you until you pass away and then makes payments to a joint beneficiary, usually your surviving spouse over the spouse’s remaining life. You can elect the amount paid to the surviving spouse to be 100%, 75%, or 50% of what was paid to you while you were alive.
- Term certain annuity allows you to reduce the risk of an early passing. You elect to ensure that payments are made for a guaranteed number of years, regardless of how long you live. A term certain can be added as part of a life annuity so that payments are made for a guaranteed number of years and continue for the rest of your life if you live beyond the guaranteed years.
The single life annuity will provide the highest monthly payment, whereas the joint and survivor benefit with 100% payout to the surviving spouse will have the lowest payment. In deciding which annuity type to elect, be sure to consider the income and retirement assets available to your surviving spouse. Consider whether living expenses will change in the event of your early passing, and keep in mind that one spouse’s Social Security will no longer be received.
Your employer may also offer a pension buyout. Buyout offers can only be made to active employees and former employees who aren’t yet receiving benefits. Buyouts are financially beneficial to companies because they reduce their financial responsibility and the cost of administering the plan payouts. Be careful in evaluating a buyout, as the offer may only replace a single life annuity and other rights and benefits will be lost. Evaluate a buyout offer as you would evaluate a lump sum pension benefit, but keep in mind that you will be taking on additional investment return risk since the buyout would be received prior to retirement age.
A pension benefit will certainly serve to bolster any retirement plan. Deciding on an annuity benefit or a lump sum payment can be challenging. Keep in mind that the choice you make can’t be changed so ensure that you give yourself enough time to make an informed decision. The decision that a former co-worker or friend makes may not be the best decision for you. Be sure to understand the risks that you take on if you accept an annuity versus the risks of taking a lump sum payout.
If you feel you could use some assistance in this area, please feel free to reach out to us.