If you’re fortunate to have a traditional pension from your employer, you’ll probably be faced with a crucial choice eventually. More employers are now offering a lump sum payout option, according to the Consumer Financial Protection Bureau. They want to relieve themselves of the financial and recordkeeping burdens of pensions.
If you take the lump sum, you’ll get your money upfront. You can spend or invest the money however you like. But you’ll give up your pension.
How can you decide what’s the best choice for you and your family? And if you take the lump sum, what’s the best way to deploy that money?
Pros and cons of keeping your pension
A pension provides a guaranteed income for the rest of your life. This is a big advantage, especially if you have a good life expectancy. You won’t run out of income no matter how long you live. A pension, though, isn’t the only way to guarantee a lifetime income.
With a pension, you don’t have to worry about investing your money wisely. It’s done for you. The Pension Benefit Guaranty Corporation (PBGC), a federal agency, guarantees your payments up to a certain amount. It covers most private-sector pension plans. You’re protected in case your employer or plan becomes insolvent.
Here’s another advantage: most plans let you provide monthly benefits to your spouse or another beneficiary after your death via a joint and survivor payout option. If you take this option, you’ll get somewhat lower payments.
Some pension plans, however, are underfunded. It’s important to check the financial strength of your pension plan because the PBGC may not cover a failed plan fully.
Probably the biggest drawback of keeping your pension is lack of control. There’s no flexibility. Your payments are set in stone. Furthermore, pension payments end when the plan participant or a surviving spouse dies, so there’s nothing to pass down to heirs.
Pros and cons of taking a lump sum—taxes and other matters
Taking a lump sum puts you in control over your money. That’s a good thing, but it comes with challenges. You’re now responsible for investing the money wisely and managing the risk of running out of money in retirement.
If you take the lump sum directly, 100% of it will count as taxable income. If it’s a modest amount, it may not matter much. If it’s a large amount, you’ll be boosted into a higher tax bracket. A lot of your money will go to Uncle Sam unnecessarily right off the top.
There’s an easy fix: just roll over the entire amount into a traditional IRA. The rollover is tax-free, and with an IRA you can spread out payments in the form of required minimum distributions (RMDs), starting at age 73, over many years. You may withdraw money before then if you like, but must wait until age 59½ to avoid IRS penalties.
How to get control over your money and guarantee lifetime income
Once the lump sum has been rolled over to an IRA, you can use all or part of that amount to purchase a lifetime income IRA annuity. That transfer is also tax-free.
That move makes great sense if you can get more income from an annuity than from your pension. Even a monthly payout that’s a bit higher can add up to a significant amount over many years.
You can choose an immediate income annuity, which sets payments that can start within a month. Or you can select a deferred income annuity, so you can choose when future payments will start, taking into consideration RMDs. The longer you can afford to delay payments, the greater the future monthly income.
Pension payments are based on the value of your account and an actuarial determination of your expected lifespan. Gender is not considered.
Income annuities act like private pensions. The insurance company uses the lump sum to provide a guaranteed stream of income. An annuity uses the same math as a pension, except the insurer does consider gender. That may disadvantage women because they are expected to live longer, but it can advantage men.
If you’re considering taking a lump sum, have your employer tell you what the amount would be. Employers can sometimes miscalculate the amount, which is typically determined by your age, your earnings history, the terms of your plan and tax withholding (if required). Make sure your most recent pension statement is accurate before accepting the amount.
Next, find out what your pension payments will be. Then, get comparable lifetime income quotes from an annuity provider representing multiple annuity companies. Make sure the agent can quote many top insurers, not just a few. Then you can learn whether your pension or an annuity gives you more income.
A lump-sum payout transfers investment risk from the pension plan sponsor to the participant. With an annuity, you can transfer that risk to the annuity insurer. Choose one that’s financially strong and has staying power.
How the numbers can work
Richard, 62 years old, is eligible to receive an in-service lump sum of $500,000 today. He has his employer tell him what his monthly pension would be at 67 when he plans to retire. He learns that an annuity would pay slightly more than his corporate pension. He also looks at his Social Security statement, savings, and investments and determines that he won’t need all of the annuity income.
He takes the lump sum now and rolls it over to an IRA. Next, he transfers $350,000 of it to a deferred income lifetime annuity, with payments to start at age 67. He invests the remaining $150,000 in a fixed-rate IRA annuity to grow and compound over time.
Based on rates as of June 2024, Richard will receive $2,506 per month for life if he takes the joint lifetime payout option. (If he dies before his wife, Sally, also 62, she will continue to receive the same income for the rest of her life.) If he declines the joint life option, his income will be $2,981 per month.
Richard’s plan gives him a foothold in the best of both approaches, with the bulk of the lump sum going to guaranteed income, plus a decent portion allocated to growth. The funds left in the fixed-rate IRA annuity can be used at a later date or passed down to the couple’s heirs.
Would a lifetime annuity give you more income than your pension plan? Perhaps. But you won’t know which one performs best until you compare.
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Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities since 1999. Ken is a nationally recognized annuity expert quoted in national media and a widely published author. A free rate comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com or by calling (800) 239-0356.