As you look toward retirement, it’s important to understand where your retirement income is coming from. If you’re vested in a pension or defined benefit plan, you may be receiving a large portion of your retirement income from your pension payout. When you retire, you’ll have several pension payout options available to you. Deciding which option is best for you is dependent on both your unique life situation and your financial needs.
Know Your Options
Before diving into the specifics of each pension election option, let’s do a high level overview. First, many pension plans offer a lump sum payout. Your pension plan may also offer a handful of different annuity payout options, including:
- Single Life
- Joint and Survivor
Finally, you might also have a Period Certain Option and the less common Social Security income-leveling pension option. Each of these elections has a different set of pros and cons. Some pension plans, such as KPERS for Kansas state and local public employees offer both a partial lump sum and reduced pension option.
Lump Sum Payout
Taking the lump sum payout is appealing if you want to take your retirement savings into your own hands. This option provides you with the flexibility to invest the money however you choose (instead of the managers of your pension plan) and then pay yourself each year. This is beneficial if you believe your plan’s investments are underperforming and you have a better investment strategy lined up. This option may also be attractive if you prefer to have more control or worried about your plan’s solvency. This option gives you access to your retirement funds when you may need them most, like for those SURPRISE expenses, possibly large, that you will probably face over a 30-year retirement.
Of course, all that flexibility can also be one of its biggest dangers because it invites the temptation for overspending. It’s much easier for you to rob your retirement cookie jar. With a pension check, it’s harder to splurge on purchases that you might regret later. Additionally, one of the main reasons people decide to opt out of the lump sum option is because there’s no guarantee that your money will last a lifetime with a lump sum because YOU take on the investment risk (instead of the pension plan). This is especially important consider if longevity runs in your family.
Electing the lump sum option from your pension is taxable if you have the funds paid directly to you. However, if you roll over that lump sum into a Traditional IRA, you’ll have much more control over when you remove the funds and pay the income tax on them. Of course, you’ll eventually have to take RMDs from your IRA at age 70 ½.
* It should also be pointed out that if you roll over your lump sum pension into a Traditional IRA and then decide to make a distribution prior to age 59 1/2, you will be subject to an additional 10% tax penalty.
Single Life Annuity Payout
A single life annuity guarantees a monthly payout for the remainder of your life. Once you die, the income stops. If you’re single, this is an attractive option because it generally pays you the highest monthly amount. You don’t have a spouse to worry about caring for in the event of your death, and it helps to create a consistent monthly income for you as long as you live.
However, if you’re married, you have a few additional considerations. If you’re relying heavily on your pension payout for retirement income as a married couple, you don’t want that money to disappear if you pass away, leaving your spouse without any income. If you have additional streams of income funding your lifestyle during retirement, a single life annuity may still be a feasible option as it has a higher monthly payout than some other annuity payout choices.
Period Certain Options
This option offers a slightly lower monthly payout then a single life annuity, while still protecting your spouse (or a beneficiary) for a limited time if you pass away. Most period certain options are either 10 or 20 years. They work like this:
The plan pays out a set amount to you every month for the remainder of your life. However, if you pass away within their defined period of time (10 or 20 years after electing the option), they’ll continue to pay the full monthly amount to your surviving spouse (or a beneficiary) for the remainder of that time frame - but not after. So, if you choose a 10-year certain option, but pass away after 3 years, your surviving spouse will receive monthly payments for the next 7 years.
Joint and Survivor Option
This annuity option was designed with your spouse in mind. You receive a set amount each month for the remainder of your life. Then, when you pass away, your spouse continues to receive either a portion, or all of, of your monthly payments for the rest of their life. This isn’t always a perfect solution to ensure they’ll be financially taken care of, it can certainly help to cushion their income if they outlive you.
It’s important to remember that most joint and survivor options have the choice to adjust your total monthly payout based on how much you want your spouse to continue receiving after you pass away. The 50% option slightly lowers the total monthly payout for the remainder of your life, then your spouse receives 50% of that total monthly figure for the remainder of their life.
The 100% option significantly lowers your upfront monthly payout during your lifespan, but your spouse continues to receive that same, full amount each month after you pass away. This can make budgeting easier because both you and your spouse will have a set figure to count on, but the lowered amount often isn’t worth the tradeoff.
Social Security Income-Leveling Option
This is a less common, but still useful, option to keep in mind. It allows you to receive larger payments before you’re eligible for Social Security, then your payments are lowered once eligibility kicks in to level your income throughout retirement. For example, if you take the Social Security income-leveling option with a $1,000-per-month Social Security benefit available at age 62, you may get a $2,500-per-month pension benefit at age 60, then have pension payments drop to $1,500 per month at age 62. Under this option, you expect to receive a total of $2,500 per month before and after Social Security. Your actual Social Security benefit may be higher or lower than initially estimated.
This option is especially attractive if you’re planning to retire early, or if you have a shorter life expectancy and want to receive larger monthly payments on the front end of retirement.
Annuity Payout Drawbacks
Monthly payments are a fantastic budgeting tool, but they’re not always the best option available to you. Most annuity payout options don’t provide an annual cost of living adjustment. So unfortunately, while your expenses in retirement generally increase 3%/year (or more like 5.5% for healthcare costs), your monthly pension amount will remain the same. And remember, this is for the rest of your life which could potentially be another 20-30 years. Ever heard grandpa complain about his pension being peanuts now?
Another common concern is the growing trend that both public and corporate pensions are underfunded which means that if there aren’t enough assets to pay out benefits to all entitled people, you may not receive what you anticipated or were promised.
Finally, a monthly pension payment doesn’t leave something to your heirs upon your death. Once you die (assuming the Single Life option) or you and your spouse die (assuming the Joint Survivor Option), the pension payments stop. On the other hand, with a lump sum distribution, you could name a beneficiary to receive the leftover money after you and your spouse are gone.
Set Goals, Then Select Your Option
Selecting a pension election option can be overwhelming. I find that it’s best to build out a comprehensive retirement plan that accounts for your lifestyle and financial goals, and then to select the option that best supports those goals.
A fee-only CERTIFIED FINANCIAL PLANNER™ professional can help you build a retirement budget and income to help you live comfortably in this new phase of your life. Interested in learning more? I’d love to talk to you! Contact me today to review your pension election options and we’ll work together to determine which is the best fit for you.
Desmond Henry is a fee-only CERTIFIED FINANCIAL PLANNER™ professional and founder of Afflora Financial Life Planning in Topeka, Kansas. He helps the retiring/retired plan their finances and invest their money. CLICK HERE to learn more.