Pensions are a luxury that very few pre-retirees are still being offered today. Most employers are shifting away from pensions because these retirement benefits create a significant strain on the company’s cash flow. However, if you have a lump sum vs. pension decision to make before retirement, this could be one of the most challenging choices of your life. Which option you select will indeed have a significant impact on your retirement lifestyle and the probability of not outliving your retirement assets. This blog will help explain the pros and cons of each option as well as the process we go through to determine the best route for our clients.
Understanding the lump sum retirement payout
Those are who are offered a pension are usually offered a one-time lump sum option as well. This means that the defined benefit retirement account can be paid out all at once in the form of a qualified rollover. These rollovers are usually transferred to an IRA to avoid income taxation at the time of the lump sum transfer. Income taxes will be due when funds are withdrawn from the account throughout retirement.
How the lump sum impacts retirement lifestyle planning
The positives of the lump sum option include flexibility, outperformance potential, and inheritance potential. Flexibility refers to the concept that you are free to do as you please with the lump sum funds. You can spend, invest, gift, etc. the funds that are received from the lump sum. The assets are under your control, allowing you to be flexible with your retirement budget and withdrawals. The lump sum option also may be a more considerable benefit over time if the assets are invested and earn a modest return. Investing the funds allows them to grow at a rate that may outpace inflation or any COLA rider on a pension. This provides the lump sum the potential to outgrow the collective pension payments. Lastly, a lump sum will allow you to pass on any remainder to your heirs. If inheritance is a vital goal, then the lump sum option may be more agreeable to your retirement lifestyle planning.
The biggest downside to the lump sum option is the lack of recurring payments. Retirement income from these assets must be withdrawn from the retirement account, and these withdrawals are not guaranteed for life. If the account value is depleted, it may become difficult to sustain the individual’s standard of living throughout retirement. This means the lump sum option is typically better suited for higher-risk individuals who may not need the guaranteed income stream of the pension.
Understanding pension payments
If you are offered a pension, you usually have a handful of options to choose from. You can have the benefits expire when you pass, you can have the benefits continue for a surviving spouse in various increments. Sometimes you can elect a period-certain benefit. Having the benefits expire when you pass creates the most considerable income benefit during your lifetime. Obviously, if any portion of the benefits is elected to continue for a surviving spouse, the benefits you will receive will be reduced. The more significant the benefit for the spouse, the greater the decrease for the insured individual while they are still alive. Period certain means the pension is guaranteed to be paid out over a set number of years (usually ten years) and if you pass before the end of the timeframe, then the full benefits will be paid to a surviving spouse until the end of the period.
How pension payments impact retirement lifestyle planning
The most significant advantage of the pension option is the reassurance of guaranteed income. Pensions provide an income stream throughout a retirement that can be used to cover monthly expenses. Pensions are great for lower-risk individuals and like the peace of mind of guaranteed payments when planning life after retirement. Pensions are also ideal for those who have consistent monthly budgets and do not expect random sums of money to pay for sporadic expenses.
The downside to the pension is the lack of freedom that comes with it. Unlike the lump sum, you do not control the assets that are used to fund the pension. This means that you do not invest the account balance nor is there any potential to leave an inheritance for your heirs. You can invest and save any excess pension payments, but that is the most you can do for growth potential. Your surviving spouse may receive a pension benefit if you elect the spousal option at retirement, but there is no benefit for your children or other heirs once you pass away. Unless you have additional assets set aside, a pension will not provide an inheritance for you to pass on.
Figuring out what you’d like to do in retirement is fun and an essential part of the planning process. Of course, every individual’s situation is different, so we cannot use a blanket strategy when making recommendations. We typically consider the client’s retirement lifestyle preference and budget, risk tolerance, inheritance goals, whether additional retirement savings are available, and more. Which option you select will surely have an impact on your retirement lifestyle planning. Also, every lump sum and pension option scenario is different. We usually see the annual pension payments around 3-5% of the total lump sum amount, but that is not always true. Sometimes individuals are offered above a 5% payout, and sometimes they are offered below a 3% payout.
At Summit Financial, we consider all these factors when analyzing our client’s potential option. Most importantly, we use a Retire Up program to help us illustrate the impact of the available options. To do this, we input all the retirement info we have for the clients into our system, and the result is a forecast of the retirement outcome and likelihood for success. By keeping all variables the same, except for the pension and lump sum benefits, we can isolate these choices and determine mathematically which route makes the most sense. However, sometimes our clients side with their personal preferences based on retirement lifestyle instead of choosing the best option mathematically. This is totally fine as long as our retirement illustration is still successful.
If you have any questions about taxes, your individual investment portfolio, our 401(k)-recommendation service, or anything else in general, please give our office a call at (586) 226-2100 or contact us. Please feel free to forward this commentary to a friend, family member, or co-worker. If you have had any changes to your income, job, family, health insurance, risk tolerance, or overall financial situation, please give us a call to discuss it. We hope you learned something today. If you have any feedback or suggestions, we would love to hear them.
Zachary A. Bachner, CFP®
with contributions by Robert L. Wink, Kenneth R. Wink, and James D. Wink.