If your company offers a pension, consider yourself lucky! Pensions are going the way of home phones.
When you retire, you’ll make several important and irreversible decisions on how to access your pension. Most pension earners face three key decisions, as follows:
- Lump Sum or Annuity? Should you take your pension as a lump sum, where you receive cash up front that you can rollover to an IRA account, or as an annuity, where you get monthly payments for life?
- What Age to Start. When should you start your pension? Should you begin at age 55 or 60, or would you get a higher monthly payment if you wait to start at 62, or 65? Even though you may retire at 55 or 62, you may be able to delay the start date of your pension, and sometimes it makes sense to do so.
- What type of survivor option should you choose? If you were to pass away shortly after beginning your pension, most pensions allow you to continue a payment amount to a spouse for life, or continue the payouts for a defined period, such as 10 years. However, you’ll get a lower monthly amount when you choose one of these survivor options.
Let’s examine each of these choices and discuss how you can determine which are best for you.
Lump Sum or Annuity
Not all pensions offer a lump sum option, but many do! So what should you do, take the cash or monthly payments for life? Let’s look at a case study to see how to do the math.
Nora is 64 and single. She can either take a lump sum of $90,721 or life-long monthly annuity payments of $602.58 per month ($7,231 per year). The numbers are shown in the Annuity vs. Lump Sum graphic.
At the top of the table, you see potential rates of return of 4%, 5%, 6%, and 7%. The columns running beneath these headings show you how long the money would last if Nora invests the lump sum of $90,721, withdraws the $7,231 per year herself, and can earn the respective rate of return on investments that you see at the top of the column.
For example, at a 5% rate of return, you can see her lump sum would run out in 17 years, at her age 80. Each point where it would run out is highlighted in yellow.
To draw out the same amount of yearly income being offered by the annuity option, and have it last to her age 95, she must have an investment that delivers an 8% rate of return after fees. Based on historical rates of return, this is not a likely outcome. The lump sum option is only good for her if she expects a much shorter-than-average life expectancy. The annuity choice provides protection against running out of money later in life, is guaranteed*, and is not dependent on stock market returns.
*Note. Companies guarantee pension benefits, but a company may default. Many pensions participate in the PBGC, or Pension Benefit Guaranty Corporation, which provides an extra layer of protection should the company default on its pension obligations.
What amount would make taking the lump sum more attractive? The answer depends on how long you want the money to last, and what rate of return you think is realistic. In Nora’s scenario:
- If she received $125,039 and it earned 4%, it could meet the equivalent annuity payments for 30 years, to her age 93
- If it earned 5%, she would need $111,158
- If it earned 6%, she would need $99,533
They are offering her only $90,721. In her case, the annuity is the better deal. The answer might change if she was in poor health, or, if she were married, and we needed to consider joint life expectancy and a survivor payout.
Three things determine the lump sum offered you; IRS-mandated interest rates, your age, and mortality tables. A math formula uses the interest rates to translate a life-long series of payments into an equivalent value in today’s dollars. The higher the interest rate, the lower the lump sum you’ll receive. That means in today’s higher rate environment, the annuity payout option may look far more attractive than when interest rates were lower.
We look at the lump sum or annuity decision as a risk management decision. Having life-long pension income reduces your risk of running out of money. The Society of Actuaries provides additional information on how to manage this critical retirement decision in their Brochure Lump Sum or Monthly Pension: Which to Take.
Start Your Pension Now or Later?
If you know you are taking annuity payments, another big decision is when to start your pension. When Eric retired, he ran estimates on what he could get from his pension based on the age he starts.
He could collect $15,888 a year at age 60, or if he waits, and begins benefits at age 65, he will get $25,568 per year. Eric is retiring now and needs monthly income, so if he waits until 65, he will need to withdraw income from his IRA account between now and 65. Eric asked us to analyze which option was best for him and his wife Julie. You can see the analysis below.
The “Annuity @ 60” column shows the annual joint life payout Eric can receive if he starts his pension early. The “Annuity @ 65” column shows the annual joint life payout Eric will receive if he waits until age 65 to begin his pension.
To do a fair analysis, we had to assume that Eric and Julie are going to spend $26,568 a year, whether they start Eric’s pension at his age 60 or at 65.
If they start the pension at 60, they will receive $15,888 from the pension and will need to withdraw $10,680 a year from savings and investments each year to have the $25,568 of income. You see this withdrawal in column A.
If they wait and start the pension at his age 65, they will need to withdraw the full $25,568 for five years and nothing after that. You see this withdrawal in column B.
Eric and Julie have $150,000 in Eric’s IRA earning 4% (shown at the top of Columns C and D). In this analysis, they take the needed withdrawals from this account.
- In column C, you see that if they take the pension early and withdraw $10,680 each year from the IRA, they run out of money at Eric’s age 81.
- In column D, you see that if they delay the start of the pension, take the $25,568 withdrawal for five years and then nothing thereafter, it leaves them with more!
The odds are significant that either Eric or Julie will live to 84 or longer. At 84, they have $129,474 more in the bank because they chose to start his pension at 65 instead of 60. Meanwhile, they spend the same desired amount along the way – they did not have to penny pinch from age 60 – 65, instead they took the money out of the IRA.
Taking the pension early, at age 60, only benefits them if they should both pass away before Eric’s age 74. You see the horizontal line running across the balances at Eric’s age 74, representing the break-even age for this decision. As long as one of them is likely to live past Eric’s age 74, waiting to take the pension will put them in a better financial position over the long-term.
Not all pension plans offer a greater benefit for delaying. There are plans where beginning the pension as soon as possible is the better decision. Don’t use a rule of thumb approach; instead analyze the offer based on its terms.
What Pension Survivor Option Should I Choose?
Another choice Eric and Julie had to make is what survivor option to choose on his pension.
With a single life option, his pension payments would stop upon his death. With a 100% joint and survivor pension option, he would receive less annual income, but the payments are guaranteed to continue for Julie’s life span as well as his own.
Here is a summary of four of Eric’s pension choices:
- Single life at age 60: $19,536 a year
- Joint and survivor at age 60: $15,888
- Single life at age 65: $34,128
- Joint and survivor at age 65: $26,568
First let’s discuss the single life choices versus the 100% joint and survivor choice. The annual difference between the two choices is $3,648 at Eric’s age 60 and $7,560 at age 65. He and Julie are the same age. Assuming the age 65 pension choice, they could pay $7,560 per year for life insurance that would continue an income to Julie when Eric passes. The question is how much life insurance is that buying?
If Eric chooses the age 65 single life annuity and dies a year later, the benefits end. Julie then misses out on $26,568 a year for potentially 25 years or more — what she would have received had he chosen the 100% joint and survivor option. The present value of $26,568 a year, for 25 years, assuming a 4% return, is about $415,000. Would he be able to buy $415,000 of life insurance for less than $7,560 a year? Perhaps, depending on his health situation. The advantage to the life insurance option is if Julie were to die first, the life insurance policy could be dropped.
The disadvantage to the life insurance option is that as people age, they often become forgetful. Older couples inadvertently miss insurance premium payments, causing policies to lapse. In addition, many people have health conditions and cannot get life insurance at a reasonable cost. We recommended Eric take the option that provides an ongoing benefit to Julie when he passes.
For better outcomes, make your pension decisions as part of a comprehensive retirement income plan. We are specialists in designing retirement income plans. If you are nearing retirement, get in touch, and let’s see how we can help you sort through your upcoming retirement decisions.
