One Size Doesn't Fit All with Pension Payout Options

Though we often hear that traditional pensions are all but extinct, there are still employers, big and small, who include them as part of their employee benefits packages.

It’s a comforting thing for those fortunate folks, knowing they have that guaranteed income waiting at retirement. But it can be the source of some angst, too, when it’s time to decide how to handle the pension payout. After all, it’s one of the most important decisions they will make regarding their financial future.

Most employers offer at least a few options for taking the money — and some have a whole menu to choose from. Each person must find the right fit for themselves and their family — but also base their choice on a number of unknowable things. Those unknowns include how long they’ll live, how long their spouse will live, how much interest rates and inflation might rise, how reliable the plan really is, and how much they could earn if they took a lump-sum payment and invested it on their own.

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The decision-making is a little easier, of course, if you already have a comprehensive retirement plan in place and know what your other income streams will be as well as your financial needs and objectives. A financial adviser can help walk you through the alternatives within the context of your plan — including the tax consequences and what your choice could mean for your legacy. For example:

Take the Highest Payment but Get No Survivor Benefits?

With this option you can choose to take your full pension with no survivor benefits (aka pension maximization option). You’ll be paid the maximum amount every month for as long as you live, but when you die, the payments will end. Your spouse (who would have to give written consent to this choice) will not receive a check.

This option is desirable for someone who is either not married or is expecting longevity. The pension maximization option provides you with the flexibility to purchase a life insurance policy for the pension holder that could provide an equivalent income stream to the surviving spouse, without sacrificing any potential cost-of-living adjustments on your benefit. (Be sure you can get a policy, based on your age and health, that has reasonable premiums and a good payout.) Then, if you as the pension owner outlive your spouse, you could cash in the insurance and still have your full pension payment.

To see how that life insurance idea could play out, consider the example of a couple, both 62 years old:

• Choosing the lifetime-only payout option with no survivor benefits would result in a pension payment of $3,500 per month. With a cost of living adjustment (COLA) of 2.5% the payment will grow to $6,330 per month on the 25th year (assuming the pension holder lived that long). That's a $2,830 increase monthly.
• Choosing a payout option that includes spousal benefits would result in a reduced pension payment of $2,900 per month. With a 2.5% COLA that check will grow to $5,245 per month on the 25th year — $1,085 less than the previous example.
• Finally, let's say you go with the lifetime-only option and purchased a permanent life insurance policy at set cost of $600 monthly. By the 25th year your net difference in pay would only be $485 per month; compared to $1,080 for the joint benefit reduction.

Take a Slightly Lower Payment to Get Limited Survivor Benefits?

Another option, which comes with slightly reduced benefits, guarantees payments — to you or to your beneficiary, whoever lives longer — to last for a set period of time. You can use this as a hedge against your premature death. With this option, your benefit is reduced and paid out over a specific time period — for example, 10 years — and if you die within that time period, your beneficiary receives benefits for the amount of time remaining in that period.

For example, if it were a 10-year period and you lived nine years, your beneficiary would receive payments for the next year, and then the payments would cease. The downside is that if your spouse happens to die first, your pension payments remain reduced, they don’t go back up.

Accept Lower Payments to Guarantee Full Survivor Benefits?

The joint and survivor option typically comes with a larger reduction in benefits. With this option, your surviving spouse could continue receiving checks throughout their lifetime. The checks the pensioner receives (and that the surviving spouse will continue to receive for the rest of their life) might be 50% or 75% of the original benefit.

If your spouse dies first, however, your benefit will not go up; you typically cannot switch over to a different payout option at that point. Usually, lifetime joint payments would be for a spouse only. Some plans may allow you to switch the beneficiary, but it is quite rare.

Go for a Hybrid Pension Payout?

If you decide on a hybrid option, you could have both guaranteed income and money to invest. You would take a significant reduction in your monthly pension payments to receive a partial lump-sum payment.

If you’re worried about inflation eroding your checks and think you could do better by investing that money in your 401(k), deferred compensation plan, IRA or 403(b), this middle-of-the-road option might be for you. You may want to avoid it, though, if you think you’ll be tempted to spend the lump-sum payout.

Go for One Lump Sum?

If you opt for a single lump-sum payment, you’ll get all your pension money at once, and you can use it as you wish. You can pay off debts, manage your tax bracket through your retirement years, do the things you want to do while you’re able, and/or create a legacy for your loved ones. This option gives you complete control. For some, this is a good thing. For others, it can be a disaster — particularly if they have little self-discipline or few other guaranteed income sources.

Like many retirement planning issues, the decision of how to handle pension payouts is specific to the needs of each employee. What works for the co-worker in the cubicle next to you may not be right for you.

Talk to your financial adviser about the alternatives available within your plan, and make sure the pension you worked so hard for works just as hard for you.

The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.

Kim Franke-Folstad contributed to this article.