Defined benefit plans, like pensions, can be a big help in retirement. But it’s important you’re strategic about how you use them. To start, let’s look at how they work. Pensions are defined benefit plans, where the terms of your pension define the benefits you’re entitled to in retirement. Usually, this is based on your years of service, salary, and other criteria. The exact terms vary based on your employer.
What you do with your pension is going to be something we determine together, but this article covers some of the main factors we’ll be considering during those conversations.
Should I take a lump sum or go with payments?
In general, a lump-sum distribution is going to be disproportionately larger than timed payouts. This is particularly true in a low interest rate environment like the one we’re in right now. That said, lump sums aren’t the right answer for everyone.
Let’s take a step back and think about income planning in retirement. The goal is to have enough income to support you and your spouse for the rest of your life, so we’ll analyze the two options in that context.
When it comes to installment payments, it’s important that you look at the terms. See if the payments continue for life (most do) or for a prescribed period of time. You’ll also want to see if the pension has a cost-of-living increase built in. (This is rare.) If there’s no cost of living increase built-in, your fixed payments will generally buy less over time as you age due to inflation, which tends to average about 3 percent per year.
If you’re married, consider the spousal support provisions of installment payments. You can often arrange for your payments to continue going to your spouse if you die first … but there’s usually a tradeoff in the form of lower payments for the duration. Depending on how significant the difference in payment amounts is, this could be a reason to consider a lump sum.
Additionally, think through your age and spending habits. If you have a hard time sticking with a budget, taking a lump sum payment could be risky, as you may be tempted to outspend what you earn.
Generally, I recommend clients go with payment plans (versus a lump sum) if they are older, single with no children, or have an issue controlling their spending. However, we always look at each case individually.
What can I do with a lump sum?
If you decide to take a lump-sum payment, the next question is what you’ll do with the money. One of the biggest perks of taking a lump sum is the flexibility involved, but that can also feel overwhelming for clients who don’t understand the different choices.
Some advisors suggest rolling the money into an annuity, since annuities mirror pensions in structure: You receive a fixed payment for a duration, often for the rest of your life. In my experience, it’s been rare to find an annuity with payment terms that are better than the original pension, so this isn’t something we do very often.
You could also roll the lump sum into an IRA which would help you in a number of ways. First, you wouldn’t need to pay taxes on the money up front. Second, you have flexibility around income planning. Taken together, this means we can be more strategic about your money in retirement, from how you budget for events, to tax planning strategies and more.
By rolling a lump-sum payout into an IRA, our biggest consideration will be around required minimum distributions (RMDs) but we can also think about strategically converting portions of the account into a Roth IRA. We can also be more deliberate about creating a family-based plan for the money.
Ultimately, what you decide to do with your pension is a major decision that we can make together as you get closer to retirement. If you have questions or concerns now, contact us for an appointment.