If you’re eligible for a defined benefit pension, you may have several payment options from which to choose. No one option is inherently better or worse than another, but each option needs to be evaluated in light of your financial and family circumstances and your expected longevity.
Annuity Options
Annuities are insurance contracts that pay guaranteed payments for the rest of your life and, in some cases, to your spouse or other beneficiaries after you pass on. Guarantees are subject to the claims-paying ability of the insurance company and surrender charges may apply if money is withdrawn before the end of the contract.
Single life annuity
This option pays a monthly benefit for your lifetime. When you die, payments end. The single life annuity may be a good choice if you have a longer-than-normal life expectancy or if you do not have any surviving beneficiaries who rely on your income.
Joint and survivor annuity
This option will pay a benefit for your life, and, when you die, a benefit will continue to your surviving beneficiary, usually your spouse, at the percentage indicated.
For example, if you take a joint and 50 percent survivor annuity that pays $1,000 per month while you are living, your survivor will receive $500 per month for the rest of his or her life after you die. If your survivor predeceases you, payments will stop when you die.
If you are married, you are required to take a joint and survivor annuity, unless your spouse consents in writing to a different payment option. A joint and survivor annuity is a good choice if your survivor needs a steady income for life. But keep in mind that the monthly payment is usually less than what you would have received through a single life annuity.
If you think your surviving spouse may pass on before you do, you might consider choosing a joint and survivor annuity with a pop-up benefit option. With this payment option, if your spouse dies before you do, your pension payout will revert to the higher single life annuity amount. Keep in mind that if you choose this option, you will receive lower default payments while you’re alive.
Period certain annuity
This option will pay a benefit for your life, and, if you die within a certain period, payments will continue to the estate or your named beneficiary for the balance of the period.
For example, if you take a 10-year period certain annuity and die after seven years, payments will continue for three years after your death. If you live past the period certain, payments will continue for your life but will stop at your death. A period certain annuity might be a good choice if your survivor is a child who needs income until he or she finishes school.
Lump-sum payments
Your pension may offer lump sum payments as an alternative to an annuity. A lump-sum payment gives you the flexibility to access money as your needs dictate, but you run the risk of outliving the lump sum if the money is managed poorly, if you live longer than expected, or if you have an overly aggressive withdrawal rate. You will assume the responsibility and risk of investing the money to get the required return to fund your retirement.
The lump sum might be a good choice if you are disciplined when it comes to money, want more control of your cash flow, are prepared to manage a large sum of money and monitor your investments, need cash up front to fund a venture, want to provide money for survivors or to charity, or have a shorter-than-normal life expectancy.
Tax implications
Keep in mind that some or all of any pension payouts you receive, either from annuities or from a lump-sum distribution, may be subject to both federal and state income taxes. The potential tax impact is something you should consider when weighing your options.
If your pension requires you take to take a lump-sum payout, you may be able to mitigate the tax impact by requesting that the taxable portion be directly rolled over into an IRA. Once you do that, you'll only have to take out a certain amount each year as taxable Required Minimum Distributions starting at age 73.
Which payment option is right for you?
When weighing your pension payment options, be sure to look at both the quantitative and qualitative factors. Consider your needs and resources, as well as your survivor’s. Here are some questions to help you get started:
- Are you comfortable investing and managing a large sum of money? Is your survivor? A survivor may feel anxious knowing that he or she has to rely on investment returns from a sum of money, whereas a monthly pension payment would be.
- Do you have the discipline to take only the amount you need each year from a lump sum? If you have other investable assets to hedge against inflation, you might want a steady, guaranteed income from your pension.
- How will needs and resources change if you or your survivor dies?
- What are your and your survivor’s life expectancies based on health, habits, and family history?
- Do you have life insurance that can potentially provide income to a survivor?
Finally, although some government pension plans, such as military pensions and Social Security, adjust payments annually for inflation, most pension annuities from private-sector employers do not have a cost of living adjustment (COLA). You can’t outlive a lifetime annuity, but you run the risk of losing purchasing power as inflation erodes its value. If your annuity doesn’t have a COLA, one way to offset the effect of inflation is to allocate other retirement resources to a portfolio whose return has the potential to outpace inflation.
For more information
Most pension plans offer the options discussed here, but you should check the specifics of your individual plan. To learn more, ask your pension plan administrator for a summary plan description.
In addition, a financial advisor or tax professional can help you determine which pension payment option may be most appropriate for you and your survivor based on your personal circumstances.
This material has been provided for general informational purposes only and does not constitute either tax advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult an accountant or professional tax advisor.
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Dan Flanagan is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or dflanagan@canbyfinancial.com
©2023 Commonwealth Financial Network® and Canby Financial Advisors.