Your choice of how to receive your pension or retirement benefits is a big decision. Both pensions and retirement accounts are sources of retirement income, but they operate in different ways.
Pension vs. Retirement Accounts
Pension plans are accounts that have been funded over time with contributions from the employee and employer. There are many factors that contribute to the value of a pension fund. Depending on the type of plan, the funds are invested and grown for the employee’s use upon retirement. Pension plans are insured by the Pension Benefit Guaranty Corporation (PBGC). Examples of pension plans include 401(k) or military retirement received by many Americans. These plans can be:
- Defined benefit: The employer guarantees a specific amount at retirement.
- Defined contribution: The employer and employee contribute set amounts.
Withdrawing Your Funds
A pension or retirement account holder can decide to take the value of the fund as a lump sum or as regular installments. If the funds are deposited into an account after they have been taxed – such as a Roth IRA – taxes can be avoided when used.
Distribution of Lump Sum
Like many people, you may like the idea of taking a lump sum. With immediate access to the funds, you can use the money as you see fit. You could invest the money in other investments that produce income. If the funds are managed well, you may be able to generate the same amount of income that the pension would provide through its regular payments. In this case, you would also retain control of the capital to pass it on to heirs.
Regular Payments
A pension or retirement plan with a good payout rate has some significant benefits. You will receive guaranteed income for life, so you won’t run out of income. The remaining funds will continue to be managed and invested. You won’t have decisions or responsibilities for managing investments. However, like the option that includes a lump sum, payments also have drawbacks.
- If you have a large pension plan, part of your future benefits guarantees may depend on the financial stability of your former employer. Benefits may be reduced if the pension fund is not managed properly. But with most pension plans, part of your pension benefit is insured by PBGC. This amount is adjusted each year and depends on your retirement year.
- The fixed monthly amount may not keep up with inflation. Some pension benefits may have built-in cost of living adjustments, but most do not.
Example of Pension Distribution
Joe is 62 years old, about to retire, and has the following options for collecting his pension:
- Single Life Pension: $2,250 per month
- Joint and Survivor Pension 50%: $2,078 per month
- Joint and Survivor Pension 100%: $1,931 per month
- Life Pension with 10-Year Certain: $2,182 per month
- Lump Sum Distribution: $347,767 to be rolled over to an annuity account
If Joe chooses the Single Life Pension option, he will receive $2,250 for the rest of his life. The monthly payment stops upon his death. If he lives for just one year, no additional amounts will be paid. If he is married, his spouse will not receive survivor benefits.
If Joe chooses the Joint and Survivor Pension 50% option, he will receive $2,078 per month. Then, upon his death, his wife will receive $1,039 per month as long as she lives.
If Joe chooses the Joint and Survivor Pension 100% option, he and his wife will receive $1,931 per month as long as one of them is alive. In this scenario, Joe takes $319 less per month. This way, his wife will continue to benefit from a significant benefit after his death. Think of that $319 per month as purchasing life insurance.
Distribution
Internal Rate of Return
To determine whether a lump sum payment is better than a fixed annuity payment, Joe needs to calculate the internal rate of return on retirement. This will be compared to the expected internal rate of return on investments he would make if he chose to take the lump sum.
To calculate the internal rate of return for an individual lifetime retirement option, Joe needs to consider some longevity expectations. First, use the present value of $347,767 and monthly payments of $2,250 each month for 20 years, with nothing remaining at the end. This equates to an internal rate of return of 4.76%. Then use the same figures but for payments over 25 years. This equates to over 6% internal rate of return and Joe reaching age 87, which is a reasonable estimate for life expectancy to use.
For a joint and survivor retirement option at 100% with payments for 25 years, the internal rate of return is 4.49%. If Joe’s wife is younger and the payment period extends to 30 years, this increases the return to 5.29%.
If Joe opts for the lump sum distribution, he would receive $347,767. He could then choose to invest this money in any manner he sees fit. If he follows a disciplined withdrawal strategy, he may be able to create a 5% annual income stream. He might also be able to increase this income each year to help offset the impact of inflation while maintaining control of his capital. However, he would need to follow a consistent investment strategy over a long period to achieve this. There are no guarantees that it will work in all market conditions. If it does work, the income Joe might expect is:
$347,767 × 0.05 (5%) = $17,388/year initially, or $1,449/month, with expected annual increases to help offset inflation’s impact. (By the time Joe reaches age 82, if investments can support a 2% annual increase, the payments would rise to $2,239/month.)
Using a present value of $347,767, and monthly payments of $1,449 that increase by 2% each year with Joe’s life expectancy being around 20 years, the future value of $347,767 would equate to an internal rate of return of about 6.5%, provided the funds are managed appropriately, thereby providing inflation-adjusted distributions while maintaining capital.
Comparing Risks of the Options
The question now is “Is the potential extra return worth it for Joe to take on the risks of managing assets himself?” Some people do not feel comfortable with money left in the company’s retirement plan. Others are uncomfortable moving the money from the plan to an IRA and managing it themselves or hiring someone to do this.
You should review the positives and negatives and the equivalent rates of return and make your own decision. In the past, about one-third of the time, a well-managed portfolio could achieve an average annual internal rate of return of less than 6%. This is due to something called “sequence risk,” which can significantly impact your returns when you’re withdrawing money. Don’t rely on the market for above-average returns after you retire.
Retirement offers can be very enticing, especially when considering the possibility of living a long time. Do not exceed the offer of the lump sum
Source: https://www.thebalancemoney.com/how-to-compare-pension-options-lump-sum-or-annuity-2388838
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