While the use of pensions as an employee benefit is on the decline, many of today’s workers nearing retirement have participated in a pension plan for the past several decades and have already accumulated a significant pension benefit. As those individuals begin to retire, they are faced with the classic decision of whether to keep the lifetime pension payments or choose a lump sum instead.
While there are several factors influencing the pension-vs-lump-sum decision, ultimately, the trade-off can be determined by calculating the internal rate of return (IRR) of the promised pension cash flow compared to the longevity of the cashflow with a lump sum return. The IRR reveals the “hurdle rate” of return that a lump sum portfolio would require to reproduce, or rise above, the sum of the pension payments through the retiree’s lifetime. Of course, the longer the retiree is expected to live, the greater the number of anticipated pension payments and the greater the portfolio hurdle rate would be.
Ultimately, though, because life expectancy will vary by the individual and the size of a lump sum relative to pension payments will also vary from one plan to the next, the benefits of keeping a pension or converting it into a lump sum will vary from one person to the next. The GATT rate is another factor to consider since this rate is used to discount pension payments and fluctuates from month or month and year to year. In some cases, choosing a lump sum will clearly be best (e.g., when life expectancy is short or the hurdle rate is especially low), while in others there will be no way for a portfolio to generate similar cash flow without a significant amount of risk – at least, as long as the pension plan itself remains secure and is not facing a potential default or being forced to rely on PBGC backing!
Solution – STA Wealth Pension Max Software and Analysis
As these solutions can be complex, the Financial Planning Department has worked closely with the Investment Committee to develop our proprietary “Pension Max Software”:
Sample Image of STA Wealth’s Pension Max Software (click to enlarge):
The Pension Maximization software allows you to review and easily visualize your options:
- Should I take a lifetime annuity that would be “guaranteed” or take a lump sum rollover payment (and take the investment risk myself)?
- If I take the lump sum, what is my “Hurdle Rate” or rate of return that I would need to assure that I don’t run out of money in retirement OR to outperform the guaranteed annuity.
- If I choose the annuity option, which is better for my financial plan (single life, joint and survivor, or other available options).
Once this important decision is made, there will be no “do overs,” so it is imperative to both understand your options and choose the best option to meet your overall goals and objectives. The STA Wealth team is equipped and available to assist you in making the best and most informed decision by combining our overall financial retirement planning process with your goals and financial portfolio.
Background on Traditional Pension Plans
If you participate in a traditional pension plan at work (technically known as a qualified defined benefit plan), you will generally be entitled to receive monthly benefits from the plan after you retire. These benefits are usually based on your age at retirement, as well as your years of service and your average earnings with the company. The normal form of benefit is typically a single life annuity. That is, an annuity that makes monthly payments to you while you are alive and stops upon your death.
If you’re not married at retirement, federal law requires that your benefit be paid as a single life annuity, unless you elect a different payment option. If you are married when you retire, federal law requires that your benefit be paid as a qualified joint and survivor annuity (QJSA), unless you elect another payment option. The QJSA is an annuity that pays monthly benefits to you while you’re alive and continues to pay at least 50 percent of your benefit to your spouse upon your death.
Depending on your plan’s provisions, you may have other payout options to choose from as well. Any optional form of benefit offered by your plan must be at least as valuable (actuarially speaking) as the single life annuity. You’ll want to select a payment option that will provide sufficient retirement income. In addition, if you are married, you will want to be sure that your spouse will have enough income in the event that he or she outlives you.
Caution: If the present value of your pension benefit is $5,000 or less at your retirement date, the plan can pay your benefit in a lump sum without your (or your spouse’s) consent. If you fail to choose whether to receive the distribution in cash or to roll it over to an IRA, and the present value of your benefit exceeds $1,000, your plan is required to automatically roll the money over to an IRA established on your behalf.
How can you choose the most optimal Pension Annuity Payout Option?
We will go into detail below on each of the annuity payout options, but there are both qualitative and quantitative factors in making a decision on which option is best for you and your family. If your pension only has annuity payout options, making the right choice can be one of the most important retirement decisions that you make. Of course it should be coordinated with your overall personal financial plan. For this decision, you must be able to answer these questions (especially if you are married). To help you better consider your options with your overall goals, we have created this decision tree:
Qualified joint and survivor annuity
The payments you’ll receive under a qualified joint and survivor annuity (QJSA) are generally smaller than you would receive with a single life annuity because they continue until both you and your spouse have died. The single-life annuity provides a larger monthly payment because it’s paid over a shorter period of time–one lifetime instead of two. Payments stop once you, the plan participant, dies.
The QJSA is typically “actuarially equivalent” to the single life annuity. That is, the present value of the smaller QJSA benefit (payable for a longer period of time) is equal to the present value of the larger single life annuity benefit (payable for a shorter period of time), based on your life expectancy and that of your spouse.
However, some employers “subsidize” the QJSA. Subsidizing the QJSA occurs when your employer’s plan does not reduce the benefit payable during your joint lives (or reduces it less than actuarially allowed), despite the longer payout period, making the actuarial value of the QJSA greater than that of the single life annuity option. It’s important for you to know whether your employer subsidizes the QJSA, so that you can make an informed decision about which payment option to select.
Example(s): Mary is a participant in her employer’s defined benefit plan and is married. Mary’s pension benefit, payable as a single life annuity, is $3,000 per month beginning at age 65. Mary’s benefit payable as a QJSA is $2700 per month, with 50 percent of her benefit (which is $1,350) continuing to her husband after her death. Mary’s benefit is not subsidized, because the benefit payable during her lifetime is actuarially reduced so that the present values of the QJSA and the single life annuity are equal.
Example(s): John is a participant in his employer’s defined benefit plan and is married. His pension benefit payable as a single life annuity is $3,000 per month beginning at age 65. His benefit payable as a QJSA is $3,000 per month, with 50 percent of his benefit (which is $1,500) continuing to his wife after his death. John’s QJSA is subsidized. The benefit payable during John’s lifetime is not reduced, even though benefits will be paid over both John’s and his spouse’s lifetimes. The present value of the QJSA is greater than the present value of the single life annuity.
Federal law requires that the survivor annuity portion of a QJSA be at least 50 percent of the amount you receive during your joint lives. However, depending on the terms of your employer’s plan, you may be able to elect a spousal survivor benefit of up to 100 percent of the amount you receive during your joint lives. Generally, the greater the survivor benefit you elect, the smaller the amount you will receive during your lifetime (unless your employer subsidizes the survivor annuity).
Tip: If the survivor annuity provided by a plan’s QJSA is less than 75 percent, a participant must be allowed instead to elect a 75 percent survivor annuity. If the survivor annuity provided by the plan’s QJSA is greater than or equal to 75 percent, the participant must be allowed to elect a 50 percent survivor annuity. This qualified optional survivor annuity must be actuarially equivalent to a single annuity for the life of the participant. (Generally, a later effective date applies to collectively bargained plans.)
You and your spouse should receive an explanation of the QJSA (including your right to waive the QJSA benefit), and a discussion of the relative values of the payment options available to you. Be sure you discuss your options with your spouse before making an election.
Tip: The QJSA must be at least as valuable as any optional form of benefit available to you.
Caution: Your plan can require that you are married for one year before you’re eligible to receive your pension benefit in the form of a QJSA.
Caution: Special rules apply to plan participants who have been divorced. In some cases, your previous spouse may be entitled to the QJSA if required by a court’s qualified domestic relations order (QDRO). Make sure to discuss your particular situation with a qualified professional.
Waiving the QJSA in favor of a single life annuity
You may waive the QJSA with your spouse’s written consent during the waiver period. The waiver period is generally the 180-day period prior to your annuity starting date. Assuming the QJSA is available to you, and your spouse agrees to a waiver, the two of you may have a difficult decision to make. If you opt for the QJSA, you have the security of knowing that your spouse will receive a guaranteed monthly income after you die. Also, choosing a QJSA often entitles both spouses to continued health coverage and other benefits that might otherwise be lost. On the other hand, waiving the QJSA in favor of a single life annuity or other payout will often increase the monthly benefit you’ll receive during your joint lifetimes. However, your spouse will lose the benefit of guaranteed survivor benefits over his or her lifetime after you die.
Caution: Be sure to seek qualified professional advice, since choosing a pension payout option can be complex and the decision will impact your financial future and that of your spouse. The decision to waive the QJSA can be one of the most important retirement decisions you will make.With a QJSA, payments continue as long as either you or your spouse is alive. By contrast, with a single life annuity, payments last for your lifetime and cease upon your death. For example, if you received one payment after retirement and then died, the single life annuity would provide no further pension payments. Your spouse would receive nothing. As noted above, the QJSA will normally be the most valuable form of benefit available to you, and is sometimes subsidized, so consider your options carefully.
Why would you waive the QJSA and instead opt for a single life annuity knowing that payments will stop at your death? One reason is that, as discussed earlier, the single life annuity generally pays a larger monthly benefit than the joint and survivor annuity. That’s because the payments are designed to last for a smaller number of years (i.e., one life expectancy instead of two). But that’s not the only consideration. Some other factors to consider include:
- Health and life expectancy of your spouse: If your spouse is in poor health or has a short life expectancy, selecting the single life annuity may make more sense than selecting the QJSA. As the plan participant and the surviving spouse, you would have the benefit of the higher monthly payout from the single life annuity for the rest of your life.
- Other sources of retirement income: If you (or your spouse) have other assets that can provide sufficient income for your spouse after your death, it may make sense to waive the QJSA and choose the larger single life annuity benefit.
- Age difference between you and your spouse: If there is a large difference between your age and your spouse’s age (with you being much older), opting for the single life annuity may make more sense. If your spouse is considerably younger than you, his or her longer life expectancy will be factored into the calculation of the QJSA benefit, resulting in smaller monthly payments. This could leave you and/or your spouse without sufficient retirement income. But again, caution is necessary–if you select a single life annuity and you die soon after retiring, your spouse may have to survive financially without the benefit of your pension for a long period of time.
- Your gender: If you (the plan participant) are female, then selecting the single life annuity may make more sense than selecting the QJSA. The reason: All other factors being equal, women are statistically more likely to outlive men of the same age. You will benefit from the higher monthly payout under the single life annuity while you are alive. By contrast, if you select the QJSA and your spouse dies first, you may be stuck with a smaller payout for the rest of your life.
- Other plan features: Be sure you understand all of the options and features available to you under your employer’s plan. For example, some pension plans have a cost-of-living adjustment (COLA) feature that allows the monthly benefits to be periodically increased to keep pace with the rate of inflation. This could be a valuable benefit for your spouse following your death. And, some pension plans offer their participants a “pop-up” provision specifying that if they initially select a QJSA payout and the spouse dies first, they can then retroactively select a single life annuity payout. This gives you flexibility to adapt if things do not go as planned. If your pension plan offers this option, it may be better to initially select the QJSA.
Waiving an annuity in favor of a lump-sum payment
Some traditional defined benefit plans allow you to take a lump-sum payment in lieu of an annuity (again, you’ll need your spouse’s consent if you’re married). Whether to take the lump sum instead of an annuity can be a difficult decision. If you take a lump sum, you’ll be giving up guaranteed income for your life (and your spouse’s life if you’re married). You’ll also assume the risk (and the potential reward) of investing the assets yourself. You’ll need to make an educated guess as to whether the lump sum will ultimately be more valuable to you than the annuity benefit–but this will depend on your actual investment experience, how long you (and your spouse) live, inflation, and other factors that are currently unknown. When making your comparison, you’ll also need to consider whether your annuity benefit would have been eligible for inflation (COLA) adjustments, or early retirement or other employer subsidies.
Caution: The guaranteed income is subject to the claims-paying ability of the annuity issuer.
Tip: To get a quick idea of the value of a lump-sum payment versus the plan’s annuity benefit, consider how much of an annuity benefit you can purchase outside the plan with that lump-sum payment.
A lump sum might be an attractive alternative if you’re in poor health. If you roll the funds over to an IRA, your beneficiary will receive any balance left at your death. Your beneficiary can then take withdrawals, or convert all or part of the balance to an annuity. You may also find the lump sum attractive if you have other resources available and don’t immediately need the income when you retire.
Caution: While you can use all or part of your lump sum to purchase an annuity, the expenses involved may cause you to wind up with a smaller annuity benefit than you could have received from your pension plan (you’ll be paying the expense of purchasing the annuity instead of the pension plan).
Advantages of selecting a lump-sum payout
The advantages of selecting a lump sum include:
- You’ll have complete control over when and how you use your pension benefits, and how those dollars are invested until you need them. Annuity benefits, like other fixed income payments, can be eroded by inflation. With a lump sum, you’ll be managing your investments yourself, and you may be able to rebalance your portfolio to counter inflationary trends.
- Your lump sum can generally be rolled over into an IRA where it can continue to enjoy the benefit of tax-deferred earnings. (If you’re over 70½, you can’t roll over any part of your lump sum that constitutes a required minimum distribution. Your plan administrator will calculate this amount for you.)
- A lump sum allows you to potentially leave funds to your heirs or to a charity. A lump sum may be particularly attractive to single employees for this reason–with the single life annuity, payments would stop after the employee’s death.
- Some pension plans satisfy their benefit obligation by purchasing an annuity for you from an insurance company. Others will not purchase an annuity, but will pay your pension benefit directly out of plan assets instead. Plan assets are held separately from your employer’s general assets. But in the event of bankruptcy, there may not be enough assets to pay all promised benefits. If your plan pays pension benefits out of plan assets, and you’re concerned about your employer’s financial condition, the lump sum may be a better choice. (Tip: Your benefit may be fully protected by the Pension Benefit Guarantee Corporation (PBGC), which insures defined benefit pension plans.)
- You can use all or part of your lump sum to purchase an annuity. However, because you’ll be paying the expense of purchasing the annuity instead of the pension plan, you may wind up with a smaller annuity benefit than you could have received from your pension plan.
Disadvantages of selecting a lump-sum payout
Disadvantages of selecting a lump sum include:
- You may be tempted to use the funds without incorporating your withdrawals into a comprehensive retirement income strategy. If you use your retirement nest egg too soon, you could find yourself without sufficient funds to last through your, and your spouse’s, retirement.
- You’ll be responsible for investing your lump-sum dollars until you need them. Investment losses, especially in your early years of retirement, could also cause you to experience a retirement income shortfall.
- You may underestimate life expectancies for you or your spouse, causing you to run out of funds too early.
- If you don’t roll over your lump sum, the entire amount will generally be subject to income tax (at ordinary income tax rates) when received, and a 10 percent premature distribution penalty may also apply if you retire before age 55 (age 50 for qualified public safety employees participating in certain state or federal governmental plans), unless an exception applies. And, you’ll lose the benefit of tax-deferred earnings.
- By opting for the lump sum, you’ll generally forego the value of any early retirement or QJSA subsidies.
- Some employers tie eligibility for retiree health coverage to the pension payment–if you choose a lump sum, you could lose your retiree health coverage.
Maximizing your pension with life insurance
As discussed earlier, under most pension plans (and depending on various factors such as the age of the two spouses), a single life annuity will pay out substantially more per month than a QJSA. Most people would like to have that extra income during their retirement years. However, most people are also concerned about providing for their spouses if they should die first. One technique for solving this dilemma is to choose the single life annuity, and then purchase insurance on your life with your spouse named as beneficiary. By selecting a single life annuity along with the purchase of a life insurance policy on the participant’s life, some couples can increase their income during retirement while also providing for the surviving spouse’s financial future. You should consider whether this strategy, commonly called pension maximization using life insurance, is appropriate for you.
Other payment options
Depending on the distribution options your plan offers, you may be able to waive the single life annuity or QJSA (with your spouse’s consent), and receive payments from the plan in some other form instead. You may also be able to choose a joint annuitant other than your spouse. In general, the same considerations described above in “Waiving the QJSA” apply when determining whether to waive the QJSA in favor of an optional form of benefit. The following are some of the more common optional forms of benefits available in defined benefit pension plans.
- Period certain: This option is generally a single life annuity combined with a guarantee period. If you die before a specified period of time (usually 5, 10, or 15 years) payments will continue to your beneficiary until the end of the guarantee period. The benefit payable during your lifetime is smaller than with the regular single life annuity because of the period certain benefit.
- Level income option: If you retire before you’re eligible for Social Security benefits (age 62 for early benefits, age 66 or later for full benefits), you’ll have a gap in your retirement income until your Social Security benefits begin. The level income option lets you receive a larger benefit from your pension plan before you start collecting Social Security, and a smaller pension benefit afterwards. In this way, your combined pension and Social Security benefits remains relatively stable during your retirement years. You can generally elect this option whether you receive your benefit as a single life annuity or a QJSA.ss
- Lump sum: See “Waiving an annuity in favor of a lump sum,” above.
Qualified pre-retirement survivor annuity
If you die before you begin receiving distributions from your defined benefit plan, your surviving spouse may be entitled to what is known as a qualified pre-retirement survivor annuity (QPSA). The QPSA is an immediate annuity, payable for your surviving spouse’s life, that is at least equal in value to the QJSA benefit your spouse would have received if you had retired upon reaching the plan’s earliest retirement age (or, if later, on your date of death).
You may waive the right to a QPSA and have your death benefits paid in some other form or to a beneficiary other than your spouse, but only if the plan permits such an election and your spouse consents to the waiver in a timely-filed and witnessed writing. If a QPSA waiver is allowed, you and your spouse should receive an explanation of the QPSA and a description of the financial effect, if any, that selecting or waiving the QPSA will have on your normal retirement benefit. Because waiving the QPSA will generally mean that your surviving spouse will not receive a survivor annuity if you die before you retire, be sure to fully discuss the decision with your spouse and your financial professional.
Caution: If you’ve been divorced, a court’s qualified domestic relations order (QDRO) can require that your QPSA be paid to your prior spouse. Be sure to discuss your individual situation with a qualified professional.
Taxation of annuity payments
In general, retirement plan distributions are subject to ordinary federal (and possibly state) income tax. The one exception is if you have ever made any after-tax contributions to the plan. Because those dollars have already been taxed, they will not be taxed again when they are paid out to you. While uncommon, if you’ve made after-tax contributions to your defined benefit plan, a portion of each annuity payment made to you will not be subject to income tax.
Tip: States generally can not tax your pension benefit if you’re not a resident of the state at the time you receive your payment. This is true even if you earned the pension in that state but have since moved.
Disclaimer: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from STA Wealth Management, LLC. Please remember to contact STA Wealth Management, LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing, evaluating, revising our previous recommendations and/or services. STA Wealth Management, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the STA Wealth Management, LLC’s current written disclosure statement discussing our advisory services and fees continues to remain available upon request.