The Pension Dilemma

Today we’ll be covering a dilemma that many soon-to-be-retirees with a pension will be facing: Take the lump-sum distribution, or take the annuity payments? A pension plan is a type of retirement plan where employers promise to pay a defined benefit to employees for life after they retire. It's different from a defined contribution plan, like a 401(k), where employees put their own money in an employer-sponsored investment program.

What seems like a simple question on its surface is actually much more complex than people think. It becomes more complicated when folks are forced to make the decision relatively quickly and potentially without any guidance from a financial advisor. The pandemic has exacerbated this problem—people getting early retirement may be forced into the decision more quickly than they’d like to. Or people retire without knowing they’ll be faced with this choice and are left scrambling to figure it out under pressure.

I know this happens from experience—in my previous life working as a senior Financial Consultant I was given a book of relatively wealthy clients and had to build relationships with them. Often, they would ignore my calls until this situation arose, and they would suddenly call me and be sitting in my office within 24 hours. Luckily I was able to help them, but not everyone has that privilege.

To be honest, the best source for getting answers specific to your situation is your financial advisor. It’s best if you work with an advisor who knows your financial picture, your psyche, and can analyze the options with you to lay out the pros and cons. In this post we’ll lay out the general analysis that should be done by either you, your advisor, or both of y’all, and offer our opinion on each option. This is not an all-inclusive list.

Annuity Option

Pros:

· The clearest advantage of choosing the annuity option is that you will receive guaranteed income for the rest of your life (for the most part, will discuss more below). You don’t have to lift a finger and you know your money will be coming every month. This could serve as a valuable supplement to social security to provide adequate income in retirement.

· No investment management required. This doesn’t give you any ability to, for lack of a better way to put it, screw up your money by making poor investment choices with the lump sum option. It removes investment risk from the equation. It also removes any time and effort that must be put into ensuring a lump sum is invested properly, when to take withdrawals, dealing with required minimum distributions once you reach that age, etc.

· You have options that could potentially provide income to beneficiaries such as your spouse and/or kids should something happen to you. These options come with consequences I’ll discuss below.

Cons:

· While investment risk may be removed, another uncertainty looms: life uncertainty. If you select the single life option (which provides the highest payout) your payments would cease altogether should you pass away earlier than expected. Then your company gets to keep the money. I would usually joke with folks and ask them if they loved their company enough to potentially give them hundreds of thousands of dollars back should something happen to them. You can guess what their answer usually was.

· You can mitigate this particular uncertainty by choosing a payout option that provides a guarantee for your spouse called a Joint and Survivor option. They will receive either 50% or 100% of your monthly payment for the rest of their life depending on how the option is structured. On top of this option, you can also add what is called a “period-certain” option which will provide payout to a beneficiary (such as a child) should something happen to both you and your spouse before the payments are fulfilled. ALL of these extra protections will reduce your monthly benefit amount, and the more extra protection provided the lower your benefit amount will become. The 50% option would create the smallest reduction, while having Joint and Survivor plus Period Certain would significantly reduce your monthly payout. I’ll leave it up to readers to decide whether this is good or bad, but some plans require the Joint and Survivor option to be chosen unless the participant’s spouse signs off approval of the single life option.

· You can actually calculate exactly how long you (and your beneficiaries) need to live in order to break even on the money you would receive if you took the lump sum. It can vary depending on the quality of the plan and which survivor options (if any) you choose. A simple calculation would be dividing your monthly payment into the lump sum to arrive at X number of months it would take to get there. However, this doesn’t factor in inflation and asset appreciation.

· Another uncertainty revolves around your former employer’s pension fund. Should bad things happen to it your pension may be severely affected.

· Last but not least if the annuity option does not offer a COLA (cost of living adjustment) you may see inflation take a big bite out of the purchasing power of your monthly payments as time goes on.

Lump Sum

Pros:

· Control, control, control. Taking the lump sum option gives you the autonomy to do with your hard-earned money as you choose. You will be able to invest it into an IRA and utilize the funds in a manner that is specific to your plan. You will be able to choose (until you reach RMD age) when you want to access the funds and how much (or little) of the funds you want to access.

· Asset appreciation. By taking the lump-sum option and investing your funds you can potentially position yourself to keep pace with or outpace inflation.

· You can also invest these funds into income-producing investments such as bonds and/or dividend-paying stocks which can supplement your social security in a similar manner to annuity payments. To provide hard numbers, let’s say your lump sum is $500k. You invest those funds into a portfolio that pays a 3% distribution. That’s $15000 dollars a year of income you can take out of your account like payments, and if you experience modest growth, you’ll likely see that distribution number rise as the value of the investments appreciates. Which leads us to the next pro:

· Asset ownership. Even if you die the day after you take out the lump sum (let’s hope that doesn’t actually happen) your beneficiaries will be entitled to every penny of it. Let’s say you invest the funds, and they grow (like in the example above) or decline slightly while still providing income to you throughout retirement—when you pass away the remaining assets will still go to your beneficiaries. While annuity payments will probably be higher than the income from invested IRA assets there is no growth and no significant inheritance for your beneficiaries. Another key point for lump sums invested in an IRA is that should something come up you can access your principal for withdrawals. With annuitized payments you are limited to your monthly amount.

· You are also no longer exposed to risk associated with the pension provider potentially going insolvent.

Cons:

· Investment risk. When you take the lump sum the fate of your funds is now in your hands. Do you trust yourself enough to manage them appropriately? Can you handle the volatility of the market should you invest the funds? These are important questions to ask yourself to make sure you are doing what’s best for you financially and emotionally.

· Planning and managing the funds appropriately becomes your responsibility now. The lump sum option does not protect you from spending all of your money too soon. You will have to determine an investment mix that is appropriate for your risk tolerance, time horizon, and withdrawal needs. Depending on your expertise and how you want to spend your time in retirement this may be a huge inconvenience. One way you can alleviate this problem is by working with a financial advisor!

So what do we think here at The WealthTenders? Obviously, we have to maintain a balance when it comes to these choices as everyone’s situation is different. With that being said, while there may be situations in which the annuity option is appropriate, we really love two things the lump sum option provides: flexibility and control.

We are full-service financial planners. Our priority is to give our clients as much flexibility as possible to achieve their financial goals. Two of the top goals we help clients work toward are a comfortable retirement and being able to help out their kids/loved ones. We believe that working with a financial advisor can strongly mitigate the uncertainties mentioned above when it comes to lump sum payouts. Your financial advisor should be able to help you invest your funds, map out a withdrawal plan, and provide income while still potentially preserving as much of your money as possible. Ultimately by doing the annuity you allow for uncertainties that we believe you have far less control over.

Our bottom-line opinion: a managed lump-sum payout can provide similar benefits to the annuity option (income) while helping to preserve your money. It’s just up to you to manage the risk yourself or work with a financial advisor who can help you do so. See our blog about finding a financial advisor and/or contact us with any questions!