How to Select the Correct Pension Option For You
Over a decade ago, when a dozen or so of our Relaxing Retirement members retired from Lucent Technologies, their only option was to receive their pension as a monthly payout. Given this, they didn’t have many big decisions to make.
Recently, however, each of these members has received an offer from Lucent to end their existing monthly pension and receive a large, lump sum pension payout.
Given that they’ve each been receiving their monthly pension check for over a decade, they wanted me to evaluate Lucent’s offer and recommend the best option for them.
After walking several of them through the pros and cons of their options, I decided that it would be a good idea to share them with all of our members.
The Traditional Pension
As a quick refresher before I reveal the pros and cons of each, for years, the traditional method of receiving a pension was in the form of a guaranteed monthly check. It was quite a simple decision to make.
However, a few years back, corporations realized that the long term liability of guaranteeing all of their employees a monthly check for as long as they lived (and possibly as long as their spouse lives) was well outside their level of expertise and comfort level.
To combat this, many companies now provide all of their employees with the option to receive their pension in the form of a lump sum versus receiving a guaranteed monthly pension for life.
If you could receive your pension in the form of a ‘guaranteed’ monthly check, why would you want to take your pension in the form of a lump sum?
There are several factors that I’d like to share with you so that you can be a little more educated before making this “irrevocable” decision.
Before I continue, let me stress the importance of the word irrevocable. This means that once you make the decision and submit your paperwork, it’s over! You can’t go back and change your mind, so take the time you need to understand all of your options before making any decisions.
- Your Survivors:
Pensions were not designed to continue forever. They were designed to be paid to you, and potentially your spouse if you elect one of the monthly joint and survivor payout options.
Let’s say you’ve worked for your employer for 31 years and now you’re retiring. When you pass away, even if it’s within the first year, only your spouse can continue to receive pension payments if you elected a joint and survivor option.
However, when your spouse dies, that’s it. Pensions were not designed to be paid out to families.
So, think about that. You could work for your employer for 31+ years and forgo years of a higher salary in the hopes that they will pay you a pension instead. If you and your spouse pass away sooner than you planned, your children and grandchildren will not see one cent of your pension.
The only way to give your family a chance to receive the pension that you’ve worked so hard to build up is to take it in the form of a lump sum and roll it over to your IRA.
If you do this, whatever amount of money you and your spouse don’t withdraw gets passed on to your children, grandchildren, or whoever else you wish to receive it.
One of the biggest fears everyone has today is outliving your income because of rising prices due to inflation.
It’s a problem that is very real.
Like our members who have been receiving a pension from Lucent all these years, if you receive your pension as a monthly check, chances are great that your pension does NOT have a cost of living element to it, especially if you work for a private sector company. (Massachusetts state employee pensions only provide a cost of living adjustment on the first $16,000 per year, so pensions only increase by $30 per month.)
Translation: fixed monthly pensions do not protect you from rising costs over your lifetime.
In other words, if your monthly pension is $5,000 per month today, in 10 years, you will still receive $5,000 per month. In 20 years, the same $5,000 per month, so there is no inflation protection.
However, as we all know, prices do go up every year. Even at a very low 3% per year pace (I recommend budgeting in a much higher inflation rate), you will need $8,064 per month to buy the same amount of goods that your $5,000 per month pension buys today. In 20 years, you’ll need over $10,800 per month!
Where will the difference come from?
As an alternative, if you choose the lump sum option on your pension and roll the balances over to an IRA tax free and invest it, at least you can own investments that have a chance to keep pace with inflation.
There’s no guarantee, but at least you have the potential to keep pace with inflation if the lump sum is invested prudently.
- Interest Rates:
One of the questions I received from most of the Lucent retirees was how did Lucent calculate my lump sum?
Essentially, it boils down to two issues:
- Your age and life expectancy: the older you are, the shorter your life expectancy. All other factors being equal, the older you are, the smaller the lump sum needed to provide to you in order to match your monthly payout option because the span of time to provide you with your monthly pension is predicted to be shorter.
- Current interest rates: the amount of your lump sum is calculated using an assumed interest rate that you can earn if you received a lump sum and had to create your monthly pension out of your own savings.
Using round numbers, if your monthly pension payout was $5,000, and interest rates were 8%, you would require a much smaller lump sum payout than if interest rates were only 2%. Creating $5,000 per month while only earning 2% is a lot harder than doing so earning 8%, hence the larger lump sum required when interest rates are low.
This is the situation that our members who retired from Lucent are in today. Interest rates are historically low, so their lump sum offers are much higher than they would be if interest rates were 8%.
- Changing Situations:
One of the events that leads an individual to call me for the first time is their desire to stop working and ‘retire’. Or, they receive an “offer” from their employer.
Something happened in their professional or personal lives that made them say, “OK, that’s it. I’m ready to retire. Now let’s find out if I can afford to do it, and then how I should do it.”
Interestingly, in many situations that I’ve personally witnessed over the last 26 years, after stopping work for about six months, and crossing off all the projects that have been on their “to-do list” for far too long, some of them hit the wall and realize that they were happier when they were working (at least part time).
So, many decide to go back to work in some capacity.
However, when they retired, if they chose the monthly pension option instead of receiving their pension in a lump sum, they’ve got a little problem.
In addition to receiving income from their new work, they are now receiving their monthly pension. And, this is throwing much of that income into a higher tax bracket.
Why don’t they just go back to their former employer and ask them to delay their pension payments until they stop working again?
The problem is the decision is irrevocable, which is another way of saying that you can’t stop the train once it starts. The monthly pension checks will continue and they have to deal with the adverse income tax consequences.
However, let’s assume for a moment that they had chosen the lump sum option, rolled the balance of the pension tax free over to an IRA, and began taking monthly withdrawals from their IRA for income.
If they went back to work, they could simply stop taking IRA withdrawals until they stopped working in the future. Once they stop, they can start withdrawing money from their IRA again each month.
Using this method, they only pay taxes on the amount of money they’re spending.
- Liquidity for Cash Requirements:
In life, many situations come up that we didn’t plan on:
- the oil burner unexpectedly goes,
- water damage that is not covered 100% by insurance,
- a grown child who is experiencing challenging times and requires financial assistance, etc.
When these unexpected events occur, or even if they are expected but necessary like purchasing your next car, this means you need a chunk of money.
If you select the monthly pension, and you don’t have a solid amount in liquid savings and investments in addition to your monthly pension, you may have a problem. And, that problem is liquidity.
The problem is you can’t call your ex-employer and request an advance on your next three pension checks! They may get a chuckle out of your request, but they can’t advance you any pension checks.
Had you instead chosen the lump sum option and rolled it over to an IRA, you choose how much you want to withdraw and “when”, so you have much more flexibility.
Think of it as your Retirement Bucket™. Any time you need money, you simply turn the tap on. If you need more, you turn it up. If you need less, you turn it down. And, if you don’t need any, your just turn it off!
You control everything.
The only time when you must withdraw funds from your IRA is when you reach age 70 ½ to satisfy the IRS’ Required Minimum Distribution.
- Health of Your Employer:
The last consideration I want to call your attention to is the future health of your employer. This may not apply to all situations, but think about this. You’re counting on your employer being healthy and honest enough to continue paying you and your spouse your monthly pension for decades to come.
How many corporations sustain themselves for that long? Especially after what we’ve all witnessed.
The answer is not many. Yes, there is something known as The Pension Benefit Guaranty Corporation which supposedly guarantees your pension. However, as they have admitted, they’re grossly under-funded.
The only way to make sure that you’re going to get everything you’re entitled to is to take it in the form of a lump sum. This way, your financial future is not tied to one corporation for the rest of your life. This is simply the principle of diversification. You don’t want your financial future tied to one of ANYTHING.
As you’ve seen, there’s a lot that goes into deciding the best way to go. In the overwhelming majority of situations I’ve witnessed, because of the flexibility, your best bet is to receive your pension in a lump sum so that you can control your outcome.
However, take the time to walk through each example I’ve given you to see what is best in your own situation. If you have a lot of other liquid investments, and you don’t have a family to leave your pension to, you may prefer to receive your pension on a monthly basis.
Remember, once you make a decision and submit your paperwork, you can’t go back and change your mind.
That’s why it’s so important to take the time to understand all of your options before making any decisions.
Years from now, you’ll be glad you did.