Pension plans, a type of employer-sponsored retirement plan that provides ongoing income after retirement, used to be very common. However today, about 15% of private sector employees and 75% of government employees have pensions, with the remainder of workers having 401k/403b plans instead.
Pensions are defined benefit plans, meaning that as a participant, you are provided with a certain payment (or benefit) upon retirement. (401k plans are defined contribution plans, where the contribution is given to you (both your own and your employer’s match) but the ultimate benefit at retirement is uncertain).
Upon retirement, the pension plan will define your lifetime benefit but as a participant in a plan, you have work to do in deciding how you want to receive that benefit. In recent weeks, I’ve worked with three clients on this very issue so I thought it was worth looking at the common payment options and things to consider if you too are faced with this important choice.
Pension – Annuity Payment Options
Upon retirement, if you stay in the plan, your pension retirement benefit will be annuitized (turned into a stream of ongoing payments). You as the participant decide how to structure those payments. Typically, this is a decision is irrevocable (you make it once and it cannot be changed) so it’s important to be well informed. Here are the common options.
Single life payments – this option gives you a set payment for the life of the plan participant only. This will be the highest amount but there will be no survivor benefits (payments end at your death and there is no transfer of any funds to your spouse or heirs (ie: no beneficiary benefits)
Single life with x% survivor benefits – plans will give you multiple single life/x% survivor options. These choices allow you to guarantee payments for your entire life, plus guarantee a set percentage of the benefits for a designated survivor.
The higher the survivor percentage, the lower the payment to you over your lifetime. For instance, if you opt for 25% of your payment to go to your survivor if you pass, your payment during your life will be higher than if you opt for 100% of your payment to continue to your survivor if you pass. Your pool of funds (ie: the face value of the annuity) is set at your retirement, so a 100% continuance to you and your survivor is likely to drain that pool faster than a 25% payment upon your death.
Above options with guaranteed periods – Many plans now offer the above choices but also add in a guaranteed number of payments (5 years and 10 years seem most common). In those options, payments are made as elected but if the participant and/or named survivor both pass before the guaranteed period is up, the remaining payments are paid out to named beneficiaries.
Lump Sum Payout
Some plans will also offer participants the option of taking a lump sum payout, thereby leaving the pension plan. This option varies greatly by plan and in some cases, you forfeit a meaningful amount of benefit if you do this so please ensure you review all details.
Under a lump sum payment, you can either take all cash immediately in one year (very rarely makes sense due to taxation of the entire amount in one year) or you can roll it into an IRA (where you can invest the funds and take cash distributions as needed). The main advantage of this option is the ability to leave funds to your heirs. Most plans don’t have any beneficiary benefits (meaning at most payments extend to your life and a survivors life – but any remaining funds will revert to the plan). By taking a lump sum, you can designate beneficiaries within an IRA and circumvent that issue if it is of concern to you. However, by moving the funds to an IRA, you are then responsible for the investing and distribution of the funds and there is no guaranteed amount/payment – so definitely an option to carefully assess and ensure you are equipped to handle.
How do I decide?
As you near retirement, your employer will provide you with an estimate of benefits under the various payment options allowed by your plan. You will need to evaluate each of those options in connection with your complete financial picture including but not limited to your other investments, plans for retirement, spouse’s pension (if any), estate planning desires, health status, planned retirement spending, and a whole host of other factors.
As with most financial decisions, there is not a “one decision fits all” path for pension plan payout options. But this decision requires a great deal of care and due diligence due to its materiality in most individuals financial journey. If you are unable to evaluate the options yourself, seek independent and professional advice. This is a not a decision to be made lightly.
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