All Things Financial Planning Blog

In this past week, I have had two clients call to ask me about the offer they have from their employer of an early retirement. The employer has offered to give the employee a lump sum or they can have a monthly pension check for the rest of their lives (plus their surviving spouse if that applies).

Curiousity got the best of me, so I went surfing to see what the rest of the world was doing. Data suggests that about 22% of employers are providing the lump sum as an option to the fixed monthly annuity payment from the employer’s pension plan. So a good number of employers are providing this option.

Is this something that my two clients should consider? There are positive sides to this and negative sides. Let’s start with the annuity side of the question.

Annuity pension payment

When you retire and elect to receive a monthly check from your pension plan (the annuity payment), you are electing to receive those payments every month until your passing. This could be one month, one year or until age 100, or somewhere in between. If you elected a survivor benefit for your spouse, or someone else, if the plan provides that feature, the survivor would receive a benefit for the balance of their lifetime. The survivor benefit amount would be at least 50% of your benefit up to 100% of your benefit; however, the benefit you receive would be adjusted downward to reflect what you elected as a survivor benefit.

In the vast majority of pension plans, the initial amount you receive as a benefit is the same amount you will receive for the balance of your life time. Thus, the amount you receive will cover less and less of your future expenses as inflation erodes the purchasing power value of your pension payment. By comparison, the social security benefit you receive is increased by the increase in cost of living each year.

While you have a choice as to when the pension benefit starts, the longer you wait to start the benefit the higher that amount will be under most pension plans. So if you delay the start of the benefit from age 62 to age 65, the age 65 amount will be a higher monthly check.

The pension benefit is taxable income at the federal level and may be taxable at the state level. Many states do not tax pension at all or may exclude a certain portion of the pension benefit from being taxed on the state return.

Lump sum pension payment

If you elect a lump sum pension amount, the amount is calculated by a prescribed formula. This formula takes into account what the interest rate is on a certain group of bonds. The lower interest rates are at the time you elect the lump sum, the higher the lump sum payment amount will be that you receive. In this respect, now is the best time for you to get this option because of the very low interest rates we have. Future calculations will probably result in a lower lump sum amount.

You have several ways to receive this lump sum payment, each with different tax consequences. If you elected to take this as a payment to you (versus made to an Individual Retirement Account (IRA)), the total amount would be subject to income tax at the federal and state level plus a 10% penalty if you are under age 59 ½ (some exceptions apply to this penalty not being imposed). This would significantly reduce the amount of the lump sum that you would have available to live on in future years.

If you elected to take this lump sum and have it transferred to a trustee as an IRA, you would have no immediate tax issues. As you withdraw from this IRA in the future, the amount withdrawn would be subject to income tax each year. The amount of tax would depend on how much other taxable income you had each year and what tax bracket you are in for that year.

With this money in an IRA and under your control, you now become the manager of this money. How you invest it will determine what happens to the value of this asset in the future. If you were able to invest it at the same rate as the rate used to calculate the amount of the lump sum, you would be receiving the same amount as what the pension plan was going to pay you each month. That may sound easy but as we have seen in recent years, returns are not guaranteed in any investment class, whether that be cash, bonds, stocks or some other asset class.

The amount you take out of this IRA is totally under your control. If you have other sources of income to meet your living expenses (maybe you found another job after this retirement), then the earnings can remain in the IRA and help the IRA grow in value. That is until age 70 ½ when the Required Minimum Distribution (RMD) rules take effect. At that time, you would have to take out 3.78% of the value of the portfolio on December 31^st of the previous year. This RMD rate will increase each year going forward as you get older thus the amount you would receive would be higher assuming the value of the portfolio was increasing.

Since this is now an IRA, you get to name a beneficiary to receive the balance in the account upon your demise. So if you should pass away a year after you take the lump sum, the majority of the IRA balance would probably be intact and would pass on to your heir for his/her benefit, a significant difference from the outcome in the annuity situation above.

As an IRA, this money now has the other benefits that IRAs have, the primary one being the ability to convert some or all of it to a Roth IRA, subject to those rules including paying income tax on the converted amount.

Further considerations

While the monthly pension check sounds like a good deal, there are some other issues to be aware of.

As noted above, the monthly amount will, for most pensions, stay the same for the rest of your life. This means less purchasing power with that pension amount as inflation erodes the real value of that pension check over time.

The pension is only as good as the financial health of your company. If the company has financial difficulty or the assets of the pension plan become inadequate to cover the liabilities of all employees covered by the plan, your pension check may become subject to what the Pension Benefit Guaranty Corporation will provide. They have a maximum amount that is paid each month based on a formula that considers what your age is and the date your company was unable to make payments. This would be a reason to take the lump sum and avoid this as an issue later in life.

Francis St. Onge, CFP®
President
Total Financial Planning, LLC
Brighton, MI