Companies offer many perks and benefits to their employees in order to keep them motivated. After all, a happy satisfied workforce leads to higher productivity which leads to more sales and more profits for the companies and a higher return to the shareholders. One of those benefits is offering employees a retirement plan.
In general. there are two kinds of retirement plans that companies offer: A defined benefit plan and a defined contribution plan. In a defined benefit plan a company offers to pay their employees a guaranteed (By the company) monthly payment at retirement and for life, depending on factors such as salary, years of service and age at retirement. For most of the 20th century, well run companies offered defined benefit plans and people spent most of their working lives in one company hoping to earn a good pension in retirement. In these retirements plan the company takes on the responsibility of making pension payments. Starting in the late 1980’s companies started offering defined contribution plans to employees. In this kind of plan, the employee makes tax deferred contributions to a retirement account (Such as a 401K account) and the company may match a portion of that contribution. The employee is responsible for picking investments from a list of available options. In this retirement plan, the employee bears the risk.
Since the risk of making the promised payments in a defined benefit plan is borne by the company, it is listed as a liability on its balance sheet. In order to reduce their liability and improve their balance sheet, several companies offer a lump sum in lieu of a stream of guaranteed payment for life. Companies that run into financial trouble often do this to improve their situation. When a company offers a lump sum, that amount is usually taken in a tax deferred account such as an IRA so that there is no immediate tax levied on the amount. Subsequently, distributions are taken periodically which is included in taxable income for the year. IRS regulation dictates the minimum distribution to take from an IRA when the employee turns 70.5. Until that age, distributions are up to the discretion of the owner.
So, Should you accept a lump sum pension payout?
While deciding whether to take a lump sum or opt for the monthly payments (annuity), you need to take several factors into account. This decision is an important one as once it is made, it is not possible to reverse it. The first and most important factor is the solvency of the pension plan and the employer. Unfortunately, this is not a straightforward decision. Pension plans must file regulatory documents with information such as assets, liabilities and rate of return assumed. Reviewing these documents gives you an idea of how well the pension obligations are funded. Ideally, the pension should be funded close to 100%. When a pension is heavily underfunded, i.e. its assets are significantly lower than the liabilities, the employer is required to fund the pension. Its ability to do this, is based on its creditworthiness. If a company is in financial trouble you are better off taking the lump sum and not taking on the risk of bankruptcy. Pension funds in the US are guaranteed by the Pension Benefit Guarantee Corporation, which steps in during a bankruptcy, however the guaranteed amount is a fraction of the expected pension and it is not something you should bank on.
If you are satisfied about the solvency of the employer and the pension plan, you should look at the details of the annuity. Many pension plans offer a choice between single life or joint survivor annuity. In the former, pension payments are made only till the employee survives while in the latter, payments last for the lifetime of both the employer and the spouse. Needless to say, a joint survivor option has a lower payment. The difference between the two can be thought of as insurance premiums and should be evaluated as such. You can also use the annuity amount, an estimated life expectancy and an assumed rate of return to calculate the present value of the payments. This can be compared to the lump sum amount to see which offers you a better rate of return. Generally, the longer the life expectancy and lower the expected rate of return on your investments, the better it is to take the monthly payments. Many pension payments also have an inflation adjustment (Cost of Living Adjustment) which is very important. Over the long run, inflation has been running around 3% per year, but certain items such as healthcare costs are increasing at a much higher rate. In addition, retirees have a much higher need for healthcare than younger people. You would want your monthly pension payments to increase over time to keep up with inflation.
The final set of factors has to do with you, your situation and your risk tolerance. If you are very conservative in your investments, then there is a risk that you will outlive your money. On the other hand, if you are able to manage your money or get an advisor to manage it for you with the appropriate level of risk and expected return, you are better off taking the lump sum. Other individual factors that come into play are financial discipline and the need to leave an inheritance for your family. If you take a lump sum you will need to be financially disciplined to not spend it all. On the other hand, if you manage your money from a lump sum appropriately, you will have the opportunity to leave something to your family.
Finally, taxes play an important role as well. If you opt for the lump sum, which is taken in a tax deferred account such as an IRA as described above, you have the flexibility to time the withdrawals and take advantage of some planning strategies such as a Roth conversion. In a monthly annuity payment, you do not have that option.
These decisions need extensive evaluation of the pension offering. Feel free to reach out to us for our opinion.