Often, the decision to take a pension annuity option over an available lump sum option rests on which option provides the greatest income. And that makes perfect sense if all of the other factors relating to this decision are excluded from the due diligence process.
But when considering all the factors that accompany this decision, whether to take a pension annuity option over an available lump sum option becomes more about control than it does the amount of the payment.
A Downward Trend With Pensions
Today we are seeing fewer pensions than we did 20 years ago, and there is a reason for this downward trend. The truth is that pensions are facing systemic problems, which is why we see private sector companies replacing these defined benefit plans with defined contribution plans such as 401(k)s.
There was a time when employees worked until they could no longer physically do their job, and when they retired, they died shortly thereafter. What we see today is employees retiring much sooner in the cycle and living longer, which translates to significantly higher pension costs that are simply unsustainable.
Speaking of sustainability, historically pensions have used 4.5% to 7.5% to calculate their projection of benefits, and once benefits begin, the projection assumes a 10-year benefit period. But the reality is that if someone retires in their 50s (which is most often the case when a pension is involved) and lives well into their 70s and 80s, you can see that 10-year estimates for life expectancy and the assumption of higher returns can go a long way to making things look great on paper.
Nearly 1 million working and retired Americans are currently covered by pension plans that are in imminent danger of insolvency, according to a 2017 Daily News article. Since this study was released, we have seen two significant stock market declines, coupled with soaring inflation rates, which only compounds the problem, leaving the future of pensions in question and underscores the need for people to consider their options more carefully.
So, what happens if a pension is unable to pay its promised benefits? According to The Heritage Foundation, the Pension Benefit Guaranty Corp. (PBGC), which is similar to the FDIC, found that for a promised benefit of $24,000 a year, they are insured only up to $12,870.
To compound the problem, this insurance has the same problem as the FDIC. The FDIC has billions in reserves but has exposure to trillions of dollars in bank accounts. The same issue exists within the PBGC. The promise of insurance benefits is not mathematically supported. If PBGC goes insolvent, that $12,870 promise is really only able to cover $1,500 under the insurance benefit.
The concern here is that when you retire and are relying on an annuity payment from a pension, you are placing a lot of trust in the pension calculations. And if the calculations are off, there is not enough insurance to recover the loss.
A Lump Sum Puts Control of Your Assets in Your Hands
I began this article by suggesting that the decision to take a pension annuity payment over an available lump sum option often rests on which option provides the greatest income. But when you add it all up, the decision to accept a lump sum offer is more about controlling and preserving your future income sources than it is the annuity payment you are promised from the pension.
Now, I am not suggesting that all pensions are destined to go broke, but there should be consideration for this possibility when structuring your income sources that are designed to sustain you for the rest of your life.
By accepting a lump sum from the pension, you gain the control over your income assets. Even if the income generated from the lump sum is less than the promised annuity payment from the pension, you gain control over the assets.
Even without the risk of a default, this lump sum option is a significant factor when you consider the following:
- Your income needs can fluctuate in retirement, and the control of the assets backing your income gives you flexibility to meet your income needs.
- You’re in a better position to take care of your spouse if you were to predecease them, by owning the assets and leaving them behind for your spouse to continue to receive income.
- Your heirs can be the beneficiaries of the assets after you and your spouse pass when a pension is guaranteed to disinherit your heirs since it doesn’t pass to your children. In some cases, a child could receive a vested portion of the pension not already paid out.
- You have access to the assets if there comes a time in your life when you may need cash, and having control over the assets grants you that option.
One other important factor to a pension lump sum is where the money will be deposited. Unless there is no need for the income and you are simply wanting long-term growth, the stock market may not be your first choice, considering the two recent declines I pointed to earlier in this article. When looking to receive income, a private annuity would be a way to simulate the pension for yourself (see my article about who should consider annuities and who shouldn’t), or you may consider using private markets (see my article about investing the way Yale does) to diversify away from some of the public market volatility.
If You Choose an Annuity, Single-Life Option Gives You More Control
Of course, not all pensions have a lump sum option, which means you have no choice but to accept an annuity payment. If that is you, there are a few things to consider before selecting your irrevocable annuity option.
As with a lump sum, the idea is to move as much into your control as possible. It can be tempting to accept a reduced benefit to support a spouse or loved one after your passing, but this option only hands more control over to the pension.
A single-life annuity option is often your highest monthly benefit and is the quickest way to get the most from the pension in the shortest period of time. The downside to electing this option is that it can leave your spouse with an income shortage because payments would stop after your passing. That is why if you are married and choose to make this election, your spouse must sign off on that decision.
So, you have two options to protect your spouse:
- You can buy insurance outside of the pension. With this option, you would accept the single-life benefit, taking the highest annuity payment and then paying a premium to an insurance contract that would pay a lump sum to the surviving spouse or children if you predecease them. This approach also gives you the flexibility of canceling the policy if circumstances change and the benefit is no longer needed.
- Or you can buy insurance through the pension. In this case, you would go for a joint-and-survivor annuity, electing to take a reduced annuity payment in exchange for the benefit to continue to your spouse if you were to predecease them. Essentially, you are paying for the insurance with your lower benefit amount. It is worth mentioning that this benefit has only one beneficiary, so it would disinherit the children if you choose this option.
Joint-and-Survivor Benefit Has Hidden Costs
One important factor when going with a joint-and-survivor annuity is the cost of buying the insurance through the pension. Of course, you have premiums in either scenario, but when purchased within a pension, there are unique circumstances that most people completely overlook.
If your pension has a cost-of-living adjustment built into it, you should recognize that because a joint-and-survivor benefit is lower, it will receive a smaller cost-of-living increase than a single-life benefit would, which means that the difference between what the maximum benefit would be and what the reduced benefit would be compounds over time. That translates to an ever-increasing cost for the insurance against inflation.
A quick example of this: Say you have a maximum benefit of $5,000 per month with a single-life annuity and a reduced benefit of $4,000 per month with a joint-and-survivor annuity. That leaves you with a monthly cost for the insurance of $1,000 per month. When you factor in a cost-of-living adjustment of 3%, that is 3% on the benefit being received. So 3% on $5,000 would be $150, whereas 3% on $4,000 would be $120, a difference of $30 per month. This income gap compounds over time. Projected out over 20 years, the gap grows to over $1,800 per month.
And if that wasn’t enough of a reason to not buy the insurance from the pension, consider the fact that the longer the pension recipient lives, the fewer years the spouse is receiving the insurance from the pension. When you think about this, buying the insurance from the pension means that you are accepting an arrangement where you are paying an ever-increasing monthly premium for a decreasing benefit.
And unlike a life insurance policy purchased outside of the pension system, this pension insurance for the spouse only extends to your spouse, unless you were to choose a child as the beneficiary.
Now, if you choose to purchase the insurance outside of the pension system, it is critical that the type of policy you purchase and the amount of insurance obtained are in alignment with what you need to protect your family.
One misstep in this process can leave your policy at risk of lapsing or expiring, leaving your spouse vulnerable to a significant income gap. (You could be susceptible to this occurring if you do not fully understand how a policy works, which can lead to a lapsed contract and loss of benefits.)
To download my free guide that will take you through the process of determining benefits and the type of life insurance best suited for protecting the benefits, visit www.thepensionelectionguide.com.
Benefits and guarantees are based on the claims paying ability of the insurance company.
Securities offered only by duly registered individuals through Madison Avenue Securities, LLC. (MAS), Member FINRA &SIPC. Advisory services offered only by duly registered individuals through Skrobonja Wealth Management (SWM), a registered investment advisor. Tax services offered only through Skrobonja Tax Consulting. MAS does not offer Build Banking or tax advice. Skrobonja Financial Group, LLC, Skrobonja Wealth Management, LLC, Skrobonja Insurance Services, LLC, Skrobonja Tax Consulting, and Build Banking are not affiliated with MAS.
Skrobonja Wealth Management, LLC is a registered investment adviser. Advisory services are only offered to clients or prospective clients where Skrobonja Wealth Management, LLC and its representatives are properly licensed or exempt from licensure.
Brian Skrobonja is a Chartered Financial Consultant (ChFC®) and Certified Private Wealth Advisor (CPWA®), as well as an author, blogger, podcaster and speaker. He is the founder and president of a St. Louis, Mo.-based wealth management firm. His goal is to help his audience discover the root of their beliefs about money and challenge them to think differently to reach their goals. Brian is the author of three books, and his Common Sense podcast was named one of the Top 10 podcasts by Forbes. In 2017, 2019, 2020, 2021 and 2022, Brian was awarded Best Wealth Manager. In 2021, he received Best in Business and the Future 50 in 2018 from St. Louis Small Business.
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