If you are vested in a defined benefit pension plan, you have a critical choice to make – that is to determine which is your best pension payout option. The choice is crucial for two reasons. First, your pension payout is a cornerstone of your retirement income plan. Second, once you choose an option, it is irrevocable. The choice of pension payout options is never clear-cut, and it can have far-reaching consequences for you and your family. That’s the reason why your choice needs to be based on your financial plan, considering several key factors, such as you and your spouse’s age, health, income needs, and income sources.
Most pension plans offer two options – a lump-sum payout and a monthly payout. The monthly payout is an annuity option that can be paid on a single life, a 50 percent payout for joint and survivor, 100 percent joint and survivor (there could be several variations of the joint and survivor options), and life with 10 years certain. Here’s a closer look at each option
The lump-sum payout option results in a one-time payment. The payment is calculated as a present value of the stream of payments you would have received with a monthly payout. Generally, the formula applies a discount rate tied to the 30-year Treasury note.
You can invest your lump sum payment in any way you choose. However, unless you roll it into an IRA, the entire amount will be counted as ordinary income in the year it’s received and taxed accordingly. If you roll it into an IRA, the taxes are deferred until you withdraw the funds. If you withdraw any funds before the age of 59 ½, they will be subject to a 10 percent penalty unless you are at least 55 years of age when you are separated from service.
There are several reasons why you might choose a lump-sum payment option.
All are perfectly valid reasons for taking a lump-sum payment instead of monthly payments with a clear understanding, of course, that you bear the risk that your investments may underperform. It’s also important to mindful of investment fees that could impact your portfolio’s performance. Choosing the right investment advisor then becomes the next critical decision.
It’s important to understand how your pension payout is calculated. Your monthly pension benefit is calculated based on your earnings and years of service. For example, your benefit amount might be equal to two percent of the average earnings you received over your last five years of service, multiplied by your total years of service. However, your actual monthly payout amount will be dictated by the annuity option you choose.
The single life annuity option guarantees a fixed monthly payout for Life. Since the payout is based on a single life, it generates the largest monthly payout.
This choice is relatively clear cut if you are single with no dependents. If you are married, you should probably look at one of the joint and survivor options. However, if you have other reliable income sources that can provide for your spouse, you could choose to maximize your pension benefit with a single-life annuity. Some couples will use a portion of the difference between a single-life payout and a joint and survivor payout to purchase a life insurance policy, which can provide a larger spousal benefit and more flexibility in determining how the benefit can be used. Another reason to choose the single-life option over a joint and survivor option is if you expect to outlive your spouse, keeping in mind that, if you are the first to die, the payments will stop.
The 50 percent joint and survivor payout option pays a reduced benefit, but it pays half that benefit to the surviving spouse. For example, if the single life monthly payout is $2,800, the 50 percent joint and survivor option might be reduced to $2,300. However, at your death, your spouse receives $1,150 a month for Life.
The 50 percent joint and survivor option is suited for married couples where the spouse depends on the pension income. It’s especially appropriate if you are the older spouse or if your spouse is in better health than you.
Instead of paying a surviving spouse 50 percent of the reduced pension amount, a 100 percent joint and survivor option pays 100 percent. To cover the higher survivor benefit, the pension amount is reduced further. A single-life payout of $2,800 might be reduced to $2,100 to provide the surviving spouse with a $2,100 monthly benefit.
This option provides the most protection for your spouse. This option is suitable if you are older or less healthy than your spouse, and there isn’t another income source.
This option has the second highest payout, but it also provides the least amount of protection for a surviving spouse. The life with 10-years certain option makes monthly payments for life, but if you die in the first ten years, your spouse receives the same payout for the remainder of the ten years.
This option is appropriate if your spouse is significantly older than you or whose health condition makes it unlikely he or she will survive the ten years.
Your pension benefit is a major cornerstone of your retirement income plan, and you only get one chance to choose the right option. Once the payout begins, your choice is irrevocable. So you must weigh your options thoroughly in light of your cash flow needs as well as you and your spouse’s age and health circumstances.
Your pension benefit is the culmination of years of hard work, but your most difficult decision – choosing your pension payout option – still lies ahead. You only get one chance to check the right box because there’s no going back once you receive a payment. It’s important to know your options. More importantly, it is essential first to understand your circumstances and all the critical factors that will inform your decision. Working alongside an experienced retirement income advisor, you can thoroughly assess your financial circumstances in light of your cash flow needs to arrive at a pension payout solution that maximizes your retirement income while protecting you and your spouse’s financial security.