Those with traditional pension plans should be aware of the topic of derisking, evaluating its potential effect on their retirement options.
In a trend that began with the Ford Motor Company in 2012, many companies have decided to give their former employees and retirees an option to receive their pension as a lump sum rather than periodic payments. This allows the companies to remove the obligation from their own books. With increasing life expectancy the advantages for the company are obvious, but is it a good choice for you to take a lump sum if you’ve been offered one?
Advantages of Lifetime Income Option
The advantage of income for life is substantial. Security of income without the need to worry about market conditions is a benefit many are understandably reluctant to part with. Since there are large variations among pension plans, it’s a good idea to fully examine your and comparing it to other market options before coming to a final (and likely irrevocable) decision. There are a number of situations where staying in the plan makes the most sense.
Those whose financial objectives coincide with the plan benefits have less of an incentive to leave. If the plan is a good fit for your situation, why leave? You may want to shop around for what the lump sum can purchase with similar objectives to the plan benefit (lifetime income for yourself and potentially a spouse, for example) but are less likely to consider options that differ from the objectives of the plan. Those who determine the plan (in an “apples to apples” comparison with other options) provides a competitive benefit will likely stay.
Some retirees will be attracted to the convenience of the plan as well. They may not have the inclination or desire to compare external investment options for the lump sum and absent any material disadvantages to the plan relevant to their situation will opt to stay in. Those receiving a lifetime income for themselves and a spouse may find remaining in the plan easier and more convenient than finding a competitive outside replacement containing a survivor benefit.
Advantage of the Lump Sum
While traditional pension plans can be a great fit for many retirees, they may not be the best option for all. Some situations exist that might lead retirees to select the lump sum.
Flexibility is a likely reason why someone would select the lump sum. While traditional pension plans offer the security of monthly income for life (or the life of the retiree and spouse), they are not as flexible as money available to invest outside of the plan. Those whose needs do not coincide with the structure of their pension plan may wish to meet their unique objectives with the lump sum.
Those who have income covered by other sources (a spouse with an advantageous pension, for example) may be less concerned with additional income, preferring to focus on the potential growth of the lump sum balance in investments. Required Minimum Distributions will still be needed once the account owner reaches age 70 ½, but the recipient can at least opt to take no more than the minimum, focusing instead on the growth of assets in their account. Those whose current income and tax situation would lead their pension payments to be taxed at a high rate are likely to find this option attractive.
In order to efficiently take advantage of the lump sum option, you’ll want to make sure you do a direct rollover or trustee to trustee transfer both situations in which you do not personally take possession of the funds prior to depositing them in your retirement account outside of the plan. (An IRA or “Individual Retirement Account,” for example.) If you do take possession of the funds personally, the IRS requires the plan to withhold 20% of the balance and you may risk additional tax consequences if the funds are not rolled over within a limited time frame.
Make sure that you fully examine the custodians and investment options available to you prior to making the lump sum election. If used to produce income, how do the payments compare to what you would have received under the pension plan? If invested for growth or another objective, what are the advantages and disadvantages including fees and liquidity? You will generally need to have already left the employer to roll over funds.
Examine Your Options with a Professional
If you still have questions regarding the best option for your situation you may want to speak to a financial professional and discuss the advantages and disadvantages of all available options. You’ll be able to address not only the investment decisions but how your choices may also affect your income taxes and estate plan and how any selection may fit in with your other income sources including Social Security.