If you’re one of the few Americans with a pension, congratulations! It’s estimated that only 20-30% of Americans have one of these valuable retirement income planning resources.
While you may not have given a second thought to your pension or its management up until now, with retirement on the horizon, it’s finally time to think about how you’ll receive payments.
Key Takeaways
- There are 4 main types of pension payouts—your company may offer all or a few more options, so be sure to ask.
- Which payment option you choose will affect your cash flow, total retirement income, and tax requirements.
- Contrary to the definition of pensions, they aren’t always assured, but there are ways to fight back.
The 4 Types of Pension Payouts
A pension is a defined benefit plan financed by companies to support their employees during retirement, unlike a defined contribution plan where employees take the lead, such as a 401(k).
Your pension guarantees a certain payout that usually corresponds with your salary and the number of years you worked for the employer. Before you retire, your employer will calculate that amount and present the options to you.
1. Single-Life Annuity
A single-life annuity is a monthly payout for the duration of your life. There are no lifetime caps on a pension, so you could live 30 or 40 years after retirement and receive the same amount every month.
This option offers the largest monthly payments and is relatively straightforward. You will need to pay taxes on the amount you withdraw, and payments end when you pass away. If you have a spouse or other dependents for whom you’re a caregiver, you’ll want to consider a joint option to ensure they continue to receive benefits after you pass.
Inflation can also reduce the buying power of annuities, so the annuity may be enough for the first few years of retirement but won’t go quite as far when you get to year 15 or 20.
2. Joint and Survivor 50% and 100%
This type of annuity covers the duration of your life and your spouse’s. Like the single-life annuity, you (or your spouse) will get a check every month. The amount will be less than the single-life option, but your spouse won’t be left without benefits should you pass first.
You can also select the percentage of the benefit your spouse will receive, directly impacting the payment size. If you want your spouse to receive 100% of the monthly annuity, that will naturally result in smaller monthly checks for you and them, but your spouse won’t see a considerable reduction of benefits when you die. Some plans even have a 25%, 50%, and 75% options.
3. Life with Period Certain
Like the other annuities, this monthly check covers your life and your spouse’s. The period-certain option also allows you to cover a dependent.
With this option, you have benefits for your entire life, and you select a period you’d like the coverage to extend to your beneficiaries, like 10, 20, or 30 years.
Think about period certain options as offering a specific coverage window, like a term life insurance policy. So if you have a 20-year coverage but pass at 25, your beneficiary won’t receive anything.
4. Lump Sum
This option is exactly what it sounds like: you can ask for a lump sum of your pension when you retire. Your employer will calculate the amount based on the present value of your future monthly income and the current interest rate.
The most significant advantage to taking a lump sum is that you can try to beat the inevitable effects of inflation. If costs rise 3% (the long-term average) throughout your retirement, your cost of living will double. An annuity provides a fixed income, which might cover your needs in the early years of retirement, but won’t allow you to maintain your standard of living over a 20 or 30-year retirement.
As with annuities, you must pay taxes on the entire sum you distribute. One course of action to minimize the tax burden is to roll that lump sum into an investment account (usually an IRA) and pay taxes only when you withdraw money.
By receiving a lump sum payment, you control those funds—which could be important if you’re concerned about your employer’s solvency. You could invest the money and potentially grow your retirement savings. Even if you invest a portion of your retirement, it requires work and creates the risk of losing that money, too.
Let’s summarize! Annuities vs. Lump Sum Payments
Source: Finra
Which Payout Option is the Best? It Depends
As with all of your financial management decisions, the option that works best for you depends on your marital status, income, dependents, and lifestyle needs.
A few questions to consider:
- Are you married? Is there a significant age difference, and will your spouse need benefits for a longer period?
- Do you have dependents? If so, do you want to leave a legacy??
- How much money do you want or need per month?
- How much do you know you’ll need for medical expenses? How is your overall health?
- What other sources of income do you have during retirement?
You should also weigh the pros and cons of each payout option to determine which “cons” you’re willing to accept. Maybe fixed income feels too risky for you because of inflation, or the potential of running out of funds is more precarious.
Whichever payout option you choose, keep in mind that you can’t make adjustments later.
Could My Pension Be At Risk?
In the world of retirement investing, pensions are generally secure and stable, but some conditions can wipe out that fund. Understanding the possible risks will only help you make good decisions and ask great questions as you choose your payout option.
Your Pension Plan Could Be Underfunded
The U.S. Department of Labor’s Employee Benefits Security Administration maintains a list of plans whose funding is considered critical, declining, or endangered, meaning they may not be able to meet the long-term obligations of a pension. In response, Congress passed the American Rescue Plan Act of 2021, which includes funding to assist plans at risk of insolvency.
Assistance usually comes through the Pension Benefit Guaranty Corporation, which acts as an insurance company for pension plan sponsors. Sponsors pay premiums to make sure their retired employees remain covered.
Your Company Goes Bankrupt
The safeguards listed above apply to this situation; however, a company’s pension plans are generally separate from the rest of the company’s finances. If the company declares bankruptcy, creditors can’t claim the pension. And, assuming there is still money in the fund, the company should still be able to pay its retirees.
Inflation and Longevity
Inflation is any retiree’s Achilles heel, even when growing at a typical rate. It reduces the purchasing power of your retirement funds and will force you to either reduce your spending or spend your money too quickly.
Even if inflation is not problematic, if you live long enough, you’ll see the cost of things grow. From groceries to housing to healthcare, the cost of living isn’t likely to decrease.
To fight against economic changes, your best bet is to diversify your portfolio with an investment fund that can earn income during retirement.
Before deciding what to do with your pension, schedule a consultation with us to review your options and set up a payout plan that works best for you and your family.
