By Dr. James M. Dahle, WCI Founder
Although defined benefit plans (aside from their “defined contribution plan in disguise” cousin the cash balance plan) are becoming less frequent all the time, there are few high income professionals who will still be getting one. At the time of retirement, the retiree may be offered multiple options, and it would be wise to consider the merits of each of them.
How to Decide Between Lump Sum or Annuity
Many plans will offer you an option to simply take a lump sum rather than the lifetime annuity option. Retirees are often confused about which one they should take. The truth is that it depends, but it is a relatively easy choice to make. First, determine the terms of the annuity option. If the annuity is fixed (i.e., pays you the same exactly amount every month for the rest of your life) you can simply compare the payout of the annuity, with the payout you could obtain from a Single Premium Immediate Annuity (SPIA) bought with the lump sum you are offered in exchange. If the annuity is paying $3,200 a month, and you could use the lump sum to buy an annuity paying $3,400 a month, then take the lump sum.
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If the annuity has some sort of inflation protection, it becomes a bit more complicated. You may be able to find a SPIA with a similar inflation-tracking component, and still do an apples-to-apples comparison, but if not, there may be a little guesswork involved—i.e., if inflation is high one option is better, if low, the other would be better.
Also, keep in mind if you are in terrible health or have dangerous hobbies, you may get a much higher annuity rate from a certain company than your employer will give you. Of course, if your health is so bad that you are unlikely to make it to your life expectancy, perhaps you ought to just take the lump sum and avoid annuitizing anything! If you already have more guaranteed income than you need or want, such as a pension from your spouse's employer + Social Security +/- previously purchased SPIAs, you may also just want that lump sum.
You might also be able to take part of your pension as a lump sum, and part as annuity. Even if your employer doesn't offer that option, you can certainly just take the lump sum and only use part of it to buy a SPIA.
Single Life + Life Insurance vs. Joint Life
Another option offered to many retirees is to buy an annuity just on their life (which pays more, but only until the worker dies) or to buy one that pays 100% of the benefit until the worker or the spouse dies. Depending on the age and health of the two spouses, that may or may not be a good deal. The best way to tell is to price a permanent life insurance policy that, when combined with the Single Life Annuity, would provide for the uncovered spouse in the event of the spouse's death. That doesn't have to be a whole life policy, a cheaper guaranteed universal life policy is probably a better option most of the time.
You simply take the difference between what a single life annuity would pay and what a joint life annuity would pay, and see how much life insurance you can get for that amount. If that amount is enough money that the second to die spouse could buy a SPIA to provide adequate income for himself (actually, probably herself given that men tend to marry younger women and die long before them), then go with the single life. Most of the time, however, just buying the joint life annuity is the better deal.
There are lots of other options too. . . sometimes the benefit is decreased by 25%–50% when the first spouse dies in exchange for a higher payout. All those moving parts make it a bit harder, but certainly not impossible to compare apples to apples. Your spouse probably won't need the exact same amount you both needed while you were living, but he will probably need more than 50% of it.
Have you (or a family member) been faced with a pension lump sum vs annuity decision? How did you decide? Was it the right decision in retrospect? Comment below!
Wow! This post was a dud. I can’t remember the last time I had a no-hitter in the comments section. Apparently very few doctors worry about THIS issue.
Try giving examples, I would like to hear more.
It is an issue I will have to deal with. I am entitled to a small monthly pension at my official retirement age, or a lump sum. Shortly after 2009, our clinic decided that our pension plan would be shut down. We all got a letter indicating how much we might expect to receive at our official retirement age or, if we chose a lump sum, what the amount would likely be. We were subsequenlty offered the option to participate in a new 403b with 2% match.
The clinic is now actively looking at moving the old plan to an insurance company, no clue yet which one, however in the current form, I’m pretty sure there will not be a inflation protection. My question would be whether in situations like this the conditions stay the same when they move it, i.e. a choice between a monthly payout or lump sum, and I am guessing that it will be less protected when moved to an insurance company.
Fortunately it’s only a very small part of our (expected) retirement income, but of course one would hope to get the max out of it.
It’s really up to the company, no guarantee. They’re just shifting the risk from the company to the insurance company. All you have to decide is whether to take the pension or take the lump sum in the future (unless they’re giving you a choice between the 403b with match and the pension).
My employer doesn’t give me much of a choice.. I’m early in my career, but my understanding is:
– my governmental 457b – self directed investing, but upon retirement I HAVE to annuities at least half of it. The choice I have will be if I want to do more…
My 401K and 403b are mine to choose what to do!
OK, I’ll help fill in the comment section for this post:
I will get a substantial pension. Because my income is over the IRS limits, part of the pension must be taken as a lump sum, and is immediately taxable (including state tax, at over 50% marginal rate, unfortunately). The remaining qualified part can be taken as a pension. It’s not inflation adjusted, and there’s no lump sum option. The fastest I could get it would be in monthly payments over 5 years into an IRA. The other options are all taxable, and include single life, joint annuity, and various other options ( 10 year certain, 20 year certain, joint and 75%, joint and 50%, etc.)
My goal is to leave a substantial inheritance for my children, and I have adequate investments to secure my retirement, so I plan on taking this as the 5 year payout. I don’t like the idea of annuities. I can get a better ROI investing on my own and eliminating the middleman. That way I can eliminate the risk of the company going bankrupt and the risk of early mortality. I don’t want or need to pay the price of the decreased ROI for the longevity insurance provided by an annuity / pension. In the worst case scenario, I can sell my house.
I calculated that if I were to wait the 5 years until I get the full payout, I would only need a 5.5% return to equal the joint life payout. I would need 6.5% to get the single life return. If I started withdrawing immediately, those numbers would be 7% and 9%. Since I would take the joint life option, I think taking the payout and anticipating a 7% return is a no-brainer.
In practice, though, I plan on using the pension money as my “first bucket” and live on that money for about 13-15 years, by which time my other investments should have grown substantially. Since this money will be going into my IRA from age 65 to 70, I’ll use some of it for Roth conversions during those low income years, and keep some of it in short term investments to use for some early IRA RMDs.
If things go well, will be an issue for me but not for a few decades. I don’t recall a post about how (or even if one should) integrate a pension into their retirement savings planning. For now I’m ignoring it, but in 10-15 years if things are still as they are now maybe I’ll make more decisions taking the pension into account.
I would not ignore it just like I don’t ignore Social Security. But there is no reason to try to blend it into your asset allocation. It just reduces your need for portfolio income/withdrawals.
Nice whiff! 😉
This is a significant issue for me as my wife has a corporate job with a pension. I include the updated lump sum value in our net worth statement and in our planning. W anticipate that it will provide in the range of $5000-6000 per month, once she hits 65, assuming that she retires at age 57 (five years from now). If you add that to expected social security for the two of us, we probably have easily $8-10k per month in today’s dollars without touching our assets.
You did not mention the tax implications of the two scenarios. I assume that if you take the pension as a lump sum, the entire amount is taxable in the year that you take it, while spreading it over time as an annuity spreads out the tax burden and leaves you potentially in lower marginal brackets (but admittedly, I have not done the math on this).
With that large of a pension, you may consider doing more Roth contributions than you otherwise would.
Pensions which are paid out over 10 years or more are taxed as regular income. Pensions paid out over less than 10 years can be paid into an IRA, and is thus tax deferred, but of course, at age 71 are subject to minimum distributions. A lump sum payment would fall into this category. However, this only applies to qualified pensions. To be qualified it has to be based on a salary under around $250,000. In my case, even though I’m entitled to a pension based on a higher salary, I only get a pension based on the 250k salary. The remainder of the pension is paid out as a lump sum at age 65 and is taxed as income (Federal + state).
So for high income earners, the pension comes in two parts: One part that MUST be taken as a taxed lump sum, and another part that can be taken as a tax deferred lump sum OR as a taxed pension.
Wow, thank you so much for the explanation. Most of her pension is qualified, but there is a sliver, perhaps 10% of the overall, that is non-qualified.
If she’s retiring at 57, but collects the pension at 65, then I think she would be getting that small taxable lump sum when she’s 65, when she would have no other income, so the tax hit on that taxed lump sum would be minimal. My situation will be different, so I get a big tax hit on a larger lump sum. ( nice to have a big lump sum. Not so nice that half or more will go to taxes. But that’s a good problem to have, I suppose )
That is good to know indeed. Not sure what my options will be. Would mine still count as qualified if transferred to an insurance company?
I certainly count on including pensions in our overal retirement income, my small one and my wife’s VA pension. Part of a fixed (and latter with COLA) income stream together with later (age 70) added Social Security, no matter how much will be left of that when we retire.
The distribution of a lump sum pension payment to you wouldn’t be taxed, I believe, since it’s being put directly into your IRA.
As far as transferring it to an insurance company, I believe that the rules were just changed to allow the purchase of certain annuities from inside retirement accounts, but I don’t know the details of how that works. Maybe WCI or someone more familiar with that could give more details. If you took the money out of the account to buy an annuity, I think that would be taxed like any IRA distribution.
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READ all the info you can on annuities. Very little on the POSITIVE SIDE if any. ANNUITIES are sold, not bought Buyer beware!
Looking forward to 2 pensions – 1 from retiring from the Army National Guard and 1 from a county hospital. Together, and assuming SS is worth half (real) in 30 years of what it is today, my expenses will be completely covered. I plan on stretching these payments out as long as possible.This allows me to be more aggressive with my asset allocation as I get older, hopefully ensuring better returns. It is nice to have an extra bucket.
My pension offers 13 options to choose from, but doesn’t have a lump sum option. I would first point out that in theory, these are all actuarially neutral. That is, there isn’t one which is a better deal than the others. You just have to pick the option that suits your needs and temperment. However, if someone is inclined to pick a particular option, and finds the same features available in an annuity that will cost less than the lump sum she could get from their employer, then that would certainly be a better option. Going that route would also let you split the annuity into smaller units from two or more insurance companies that could potentially have better state guarantees in the event of insurance company failure, and of course would diversify that risk.
My options include:
a fixed payout over 5, 10, 15, or 20 years, to me or my estate.
A guaranteed reduced 5, 10, 15 or 20 year payout, with continued payments to me for life.
A single life annuity.
A joint annuity paying the second life 50%, 66 2/3%, or 75%.
A joint annuity paying a reduced 100% to each, but if either dies before 15 years, they get the single life payout for the remainder of the 15 years.
Note that when there’s a joint annuitant, the amount that the payments are reduced is based on the age of the younger of the two. So someone retiring with an older spouse won’t see much of a reduction when taking a joint life option when compared to someone with a much younger spouse. So someone with a younger spouse would do better to take the cash, or take the single life and add a life insurance policy. But presumably, you have enough retirement savings not to need that, regardless.
I also noted that the 20 year certain fixed payout ( with no payout after 20 years ) is just about exactly the same as the single life payout, so clearly they are assuming a life expectancy to 85. That’s a good benchmark to work from. I also assume that the lump sum payout, if it’s there, is also the equivalent of all of the listed options. So someone who is comfortable managing their own money, and values having money in their estate, should do better taking the cash.
I’ve thought about it in the same regard as AlexxT in that if I retired early I would take the DB plan annuitized in order to allow my other investments to grow further and wait out SS. Dont have one as of yet so its still in planning stages.
OK, so I will represent some of your military fan base. Yes, I will have a pension. In some ways this comment belongs more in the “should I join the military to pay for school” posting, because it has little appeal for the non-military readers – so feel free to re-route it.
The military has a defined benefit plan that is currently being converted to a hybrid, with a tentative start date of 2018. For me, active since 1990, I will retire in 2020 at age 56 and immediately start drawing a pension of about $8000 a month. (30 years x average O-6 base pay for last 36 months of service). This is adjusted annually for inflation but not deflation.
Corollary 1: Don’t join the military unless you have fun and love it. You can make more money, save and invest the difference, and generate much more than this as an annuity or equivalent.
Corollary 2: If you are one of the fortunate few who get to 30 years active duty, it really creates a very steady ‘base’ cash flow and IMHO you do not ever need to buy bonds or other more conservative investments. I have 100% of my TSA and taxable accounts (Vanguard) in stock mutual funds, and plan to leave them invested this way even through my retirement. My pension cannot be taken as an annuity (this will change a little for people just entering service) so for me it is one giant T-bill that pays ~$96,000 a year adjusted for life.
I’d be interested in any challenges to my thinking on this
I don’t think there is any problem with your thinking. Pensions, SPIAs, and Social Security put a floor under your spending allowing you to take more risk with your portfolio.
My FIL married to diabetic obese hypertensive MIL waived the SBP when he retired from the military to get an extra $100+/month. Cue his dx of CML when he hit 65 yo 10+ years back. They benefited from a one time offer to buy back into SBP since then so MIL, with now much higher chance to survive him as she’s made it to 75 already, can rest a little easier.
While my spouse and I have pretty good savings we do really like his COLA Army pension and value it for me if he predeceases me, so we miss out on $300+/ month for that insurance (and a few c/ month to get the teenager a benefit if we both die before she’s an adult). But I remind him to UP his income should he outlive me to be a very merry widower, and not to remarry or at least recall what a hot financial property he’ll be if he considers it. (I’m not saying she’ll be a gold digger, but she might well be.)
Thank you for this post. I’m with the federal government, which means that I’ll get a pension when I retire (at age 57, but hopefully earlier!). Do you have any thoughts on how a pension should affect the rest of your retirement planning? Should I feel more comfortable with a more aggressive allocation given that my pension guarantees me 30% of my pre-retirement income from retirement until death?
Yes, a pension should cause you to lean more toward Roth contributions and to be a little more aggressive with your asset allocation.
I wonder if I could get your advice on my personal situation.
I am 39 and leaving my first job after 4 years. I have a pension with multiple distribution options; trying to decide which is best. I can take a lump sum of $48K minus taxes, roll it over to my 401k, or select from a range of annuity options with monthly benefits ranging from $211-247.
My wife is also a physician. We are both healthy and I’ve followed your plan so we’re covered in the case of death or disability, ie we don’t need the money now. In this case it would seem best to roll it over into my 401k and let it grow. Am I correct in that? Are there other factors I should consider?
Thank you for all that you do!
Yes. Roll it to your 401(k). The other two options are lousy.
A fourth option is to pay the taxes on it and roll it into your Roth IRA.
A fifth would be to just roll it to an IRA. If Congress outlaws BD Roths as planned, that wouldn’t be a bad option either. Your state may provide less asset protection to IRAs than 401(k)s get though.
Thank you! I hadn’t considered the roth option. Considering we may not be able to use that in the future that is a very attractive option!
Conversions might be going away too for high earners next year.