How to Get the Most Out of Your Pension

For many American workers, a defined benefit pension plan is an artifact that has gone the way of phone booths, cassette tapes and percolator coffee.

But millions of federal and state government workers, teachers, and individuals who work for companies that continue to provide this once-common benefit are still eligible for a pension when they retire. There are even signs that pensions are making a minor comeback. In January, IBM discontinued contributions to its employees’ 401(k) plans and defrosted a defined benefit plan it froze more than 15 years ago. IBM’s move was influenced by favorable market conditions that could compel other companies to thaw out frozen pensions.

While a guaranteed payment for life is a valuable asset, getting the most out of a traditional pension involves more than bidding farewell to your coworkers and waiting for the monthly checks to roll in. You’ll need to make several important decisions — most of them irrevocable — that could affect the financial security of you and, if you’re married, your spouse.

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Lump sum versus annuity payments

Many private employers give workers who are eligible for a pension two options: a lump sum or a lifetime annuity payout. Determining the right one for you depends on multiple factors. In addition to determining which option will deliver the most income, you’ll want to consider the health of your pension plan, how long you think you’ll live, the other assets you have in your portfolio and your risk tolerance. 

Start by assessing the likelihood that your pension will be around as long as you will. (For reasons we’ll discuss below, you should include your spouse in this calculation, too.) Most private-sector pension plans are insured by the federal Pension Benefit Guaranty Corp., so if your employer files for bankruptcy and demonstrates that it can’t meet its pension obligations, its liabilities will be transferred to the PBGC. If that happens, your pension won’t disappear, but it could be reduced. 

In 2024, the maximum payout is $85,296 a year, or $7,108 a month, for a 65-year-old retiree. (The monthly payment is lower if you retire earlier or elect survivor benefits.) Some higher-paid workers, such as airline pilots, have ended up with lower payouts than they would have received if their plan hadn’t been terminated.  

Even if your employer doesn’t file for bankruptcy, it may decide to off-load the plan by purchasing annuity contracts from a third party — usually an insurance company — that will assume the responsibility of providing benefits to plan participants. These transactions, known as pension risk transfers, remove pension liabilities from employers’ books and relieve employers of their obligation to continue paying premiums to the PBGC. 

The Federal Reserve’s interest rate hikes since March 2022 have made pension risk transfers even more appealing because under the formula used to calculate companies’ pension liabilities, higher interest rates usually lower the cost of purchasing annuity contracts. Nearly 90% of companies plan to divest their pension liabilities sometime in the future, primarily through annuity buyouts, according to a 2023 MetLife survey.  

Once your pension is transferred to a third party, it’s no longer backed by the PBGC, although insurance companies are subject to state regulations. Some recent pension risk transfers have raised concerns among eligible employees, who say their employers failed to comply with the Department of Labor’s requirement that companies seek out the safest available annuity. Employees of AT&T and Lockheed Martin sued those companies after they transferred their pension plans to Athene, a subsidiary of Apollo Global Management, which is a private equity firm. The lawsuits contend that Athene engages in risky investment activities in offshore firms, which could jeopardize its ability to make payments to retirees. Athene maintains that it is well capitalized and makes sound investments. 

Taking a lump sum eliminates the risk that your former employer or third-party provider will be unable to meet its obligations if you choose the annuity payout instead, but there are trade-offs. You’ll have to decide how to invest the money and calculate how much you can withdraw each year so your savings will last as long as you do. 

In addition, the amount your employer offers as a lump sum may be worth much less than the value of a monthly payment. “In the vast majority of cases, the annuity is worth a lot more than the lump sum,” says Norman Stein, senior policy counsel for the Pension Rights Center, a nonprofit advocacy group. 

You can gauge the value of your lump sum by comparing it to the payout you would get from an annuity purchased on the open market. For example, suppose you’re 65 years old and are offered a lump sum of $300,000. According to Charles Schwab’s annuity calculator, if you had bought an annuity in April, you would have received a monthly payment of $1,971, or $1,655 had you opted for a joint-and-survivor payout (these figures are subject to change, based on interest rates). If your pension will pay out a higher monthly amount, taking the annuity is probably the better option. 

In addition, your lump-sum offer should include a section entitled “The Relative Value of Pension Payments” that compares the value of the lump sum being offered against the value of the monthly payouts, says Jaime Quiñones, a certified financial planner in Marlboro, N.J. “You’ll be surprised how often this figure represents a number significantly less than 100% of the normal pension payment amount,” he says. One of Quiñones’s clients recently received a lump-sum offer that was worth about 72% of the value of the monthly payout. (He chose the annuity.) 

“We tend to default toward annuitizing the pension with a joint-and-survivor benefit because the wholesale pension stream is almost always better than you could do if you took a lump sum and bought an annuity yourself,” says Rick Brooks, a CFP in Solana Beach, Calif. 

Other factors to consider when weighing a lump sum against a monthly payout:

Your life expectancy. One of the main benefits of annuitizing your pension is that you won’t outlive your money. But if you have a chronic illness that will likely shorten your life span, a lump sum could provide money for health care and allow you to enjoy the time you have left. You may also consider taking a lump sum if you have other sources of income and want to leave an inheritance, says Nicholas Bunio, a CFP in Berwyn, Pa. By investing the lump sum, you have the potential to increase its value before it passes on to your heirs, he adds.

The calculator at www.calculator.net/pension-calculator.html will help you compare the value of your lump sum against monthly payouts, based on your estimated rate of return on your investments and any cost-of-living adjustment provided by your pension. A higher rate of return increases the likelihood that your lump sum will provide more income than an annuity payout, but that also requires you to take more risk. 

Inflation. If you choose a lump sum and invest it in the stock market, you have a better shot at staying ahead of inflation (although that also requires you take more risk). Most traditional pensions aren’t adjusted for inflation, so the buying power of your monthly payout will decrease as prices rise. Jorie Johnson, a CFP in Brielle, N.J., advises clients who receive a traditional pension to put aside 30% of their monthly payout in a savings account so they’ll have a cushion to cover an increase in their expenses. 

Taxes. The IRS taxes monthly payments from a pension at your ordinary income tax rate, and 26 states tax at least a portion of pension income. Depending on the size of your pension and other sources of taxable income, you could find yourself in a higher tax bracket, particularly when you’re required to take minimum distributions from your tax-deferred accounts (RMDs currently start at age 73). 

If you take your pension as a lump sum and roll it into a traditional IRA, you’ll still pay taxes on withdrawals, but you’ll have more control over how much you take out — at least until RMDs kick in. That gives you the flexibility to take larger withdrawals when your tax rates are lower — because you have less income from your investments, for example — and smaller withdrawals when they’re higher. In addition, you can convert some or all of the money to a Roth IRA. You’ll pay taxes on the conversion, but the money will grow tax-free, and you won’t have to take RMDs.

Second thoughts. Once you choose the annuity option, you’re usually locked into monthly payments for the rest of your life. If you need funds for catastrophic medical expenses or long-term care, “you can’t call your pension and ask for more money,” Bunio says. 

If you take a lump sum, you can always use that money, or a portion of the amount, to buy an immediate or deferred annuity sometime in the future. And if you wait until you’re older to purchase the annuity, the monthly income will be higher. 

Single versus joint-and-survivor options

If you’re married and opt for a monthly payout, you’ll need to decide whether to take a single-life payment or the joint-and-survivor option. Taking the single-life payment will deliver a larger monthly benefit, but your pension will end when you die. With the joint-and-survivor alternative, payments will be smaller, but they’ll continue for as long as you or your spouse is alive.

Unless both spouses have a pension, the joint-and-survivor option is usually the better choice because it guarantees that one spouse will receive payouts for as long as he or she lives, financial planners say. Social Security is essentially a single-life annuity because your payments end when you die, which means a reduction of up to half of the couple’s combined benefits, Brooks says. “The last thing you want to happen is for the spouse to also lose the pension,” he says. 

Stacy Francis, a CFP in New York City, says she advised her mother, who worked for the state of Michigan for 35 years, to take a single-life payment when she started her pension because she expected her mother to outlive her father, who had suffered two heart attacks and a stroke. Francis’s mother opted instead for the joint-and-survivor payment, and as it happened, her father outlived her mother by 14 years. 

“She was a smarter woman than I am,” Francis says. “He had 75% of that pension, and it allowed him to live in a financially secure way. For a lot of couples that go with joint-and-survivor, having that pension can literally save them financially.” 

The survivor benefit is based on a percentage of the pension participant’s benefit. You may have a choice, for example, of providing 50% or 75% of benefits to your spouse. The higher the survivor’s benefit, the lower your monthly payments. Choosing the joint-and-survivor benefit typically reduces payouts by about 10%, Bunio says, “but even if it’s 20%, would you want your spouse to lose 100% if something happens to you?” 

If you’re eligible for a pension from the Federal Employees Retirement System (FERS), there’s an even more compelling reason to choose the joint-and-survivor option, says Wes Battle, a CFP in Rockville, Md., whose practice includes many federal government employees. Retired federal government employees and their spouses are eligible for health coverage under the Federal Employees Health Benefits (FEHB) program, but if you opt for the single-life option, your pension payments and your surviving spouse’s FEHB coverage will end when you die, Battle says. 

Your spouse would still be eligible for Medicare (and some federal retirees enroll in both Medicare and the FEHB), but that could mean switching health providers, possibly when your spouse is well into his or her eighties, as well as paying late-enrollment penalties. Battle says he recommends the single-life option only when both spouses are eligible for federal pensions. 

Your investments

If you choose the annuity payout, it’s important to view it as one component of your overall portfolio and invest accordingly. From an asset-allocation point of view, your pension and Social Security benefits are essentially the fixed-income portion of your portfolio, Francis says. Because income from these two sources is guaranteed, you can invest funds in your IRAs, 401(k)s and other accounts more aggressively than you would if you didn’t have a guaranteed income stream.

This strategy can also help you stay ahead of inflation. Unless your pension has a cost-of-living provision, “it’s only going to buy half as much 20 years from now.” Brooks says.

Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.

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