As a retirement option, pensions are increasingly on the endangered species list. Largely replaced with 401(k)s and other employee-managed accounts, pensions at one time were overwhelmingly popular. Baby Boomers who worked between the 1960s and 1980s were often provided a pension for their retirement plan. These days, unless you’re a government worker or one of the lucky 15% of today’s employees, odds are you don’t have one.
If you’re one of the fortunate few with a pension, you have a critical decision to make: which pension option should you choose? Making the right decision for your unique situation could mean the difference between a comfortable retirement or one plagued by high income taxes and lost funds.
Monthly Payout Options
There are three ways to make your pension pay out monthly: single life, joint life and period certain. If you don’t have a spouse, the single life option is likely your best choice. The payouts from single life tend to be larger than other options because they only last over your lifetime.
If you have a spouse, you’ll want to make sure they’re financially stable after you pass. With the joint life option, you can make your payouts stretch over your lifetime and into your spouse’s. The amount of money paid to your spouse after your death is pre-arranged and is often about 50-75% of the original monthly payments. This option is the default if you’re married, so if you want to select a single life payout, your spouse will have to sign paperwork to waive their benefits.
Your pension can also provide a monthly payout over a set amount of years, which is called period certain. This will typically provide the largest monthly payment because there’s a clear end. People in good health who retire young could have many decades of single life payments, while people receiving period certain payments over 10 or 15 years know exactly when theirbenefits will stop. If the retiree passes away, the remaining payments are paid to the beneficiaries, usually a spouse or child.
None of these monthly payment options can be stopped or adjusted, so make sure the combination of your required minimum distributions, Social Security benefits and pension payments won’t bump you into a higher tax bracket. It’s wise to consider your current health and life expectancy to determine which type of payout will maximize your income. If you think you’ll live 15 or 20 years into retirement, a period certain plan might cause you to miss out on years of retirement benefits.
Rather than waiting for years to reap their full benefits, retirees can choose to receive their pension dollars all at once with the lump-sum payment option. The payment is based on your estimated life expectancy. With a lump-sum payment, you have full control and flexibility for spending, saving or investing those funds. Instead of keeping your company in charge of investing your pension dollars, you have the power and responsibility of investing.
There are certain risks to consider with a lump sum payment. If you tend to be a spender, monthly payments could help keep you in check, whereas a lump sum gives you the opportunity to waste your dollars on unnecessary expenses. In addition, The Employee Retirement Income Security Act of 1974 (ERISA) provides extra protection and prevents pension payments from being misused by former employers, but taking a lump sum waives the protection of ERISA. Despite owing millions in a civil judgment, O.J. Simpson still has a retirement plan from the Screen Actors Guild with $5 million and an NFL pension plan. If he would have taken a lump-sum payment, those funds wouldn’t be protected by ERISA.
On the positive side, lump-sum payments can allow for a better tax strategy. You can use a Roth conversion to put your lump-sum payment into a Roth IRA, which could save you from being pushed into a higher tax bracket in the future. Plus, after-tax accounts, like a Roth IRA, save you from paying any taxes when you withdraw. Converting your pension into a Roth or traditional IRA account allows you to create a legacy to pass on to your kids or other beneficiaries. With single or joint life payments, the pension stops paying as soon as the recipients pass.
Weighing Your Options
As a financial advisor, clients often ask me what the best option is, but the truth is there isn’t one. The pros and cons of each option vary from person to person, and the best way to make your decision is to play out the potential scenarios. Imagine what would happen if you pass away 20 years down the road, or even later, and acknowledge the outcomes of each situation. At Asset Preservation Tax & Retirement Services, we use our extensive experience with retirement plans to help our clients sort through the possibilities and choose the right options for their unique situations. I always tell my clients the choice simply boils down to making an informed decision based on the potential upsides and downsides.
Be wary of listening to advice from friends or coworkers. Every person's health, desired lifestyle, risk tolerance and life expectancy are different. What’s right for one person might not be a good fit for you. Avoid the watercooler talk and think through your personal situation without being swayed by the advice of others. After all, your retirement dreams are one-of-a-kind, be it relaxing at a beach condo or becoming a devoted community volunteer, and your retirement strategy should be just as unique
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.