ByKevin M. Reardon

Although traditional defined benefit plans (pensions) are quickly going away, there are still many people who have access to a pension. Most people think of a pension as a monthly income stream that will replace a portion of their earnings. That is always an option. However, many plans also offer participants the option of electing to take a one-time lump sum payment rather than the lifetime income stream. Options are always good, but now you have to make a decision. So, what should you do?

Although the easy answer is "it depends", we can give you a strong framework for making this decision. Let's evaluate this decision from two perspectives. First, we'll review the pros and cons of each strategy. Then we'll dig into the mathematical equation of evaluating the two options.

Pros and Cons

The sections below indicate the pros and cons of each strategy. Not surprisingly, the "con" of one strategy might be the exact opposite of a listed "pro", and vice versa.

Pros of annuitization:

  • Reliable and predictable cash flow
  • Eliminates market risk
  • Ability to invest other assets more aggressively
  • High surety you won't outlive your assets

Cons of annuitization:

  • Irrevocable/permanent decision
  • Risk of pension default
  • No inflation adjustment (typically)
  • Reduced tax planning opportunity
  • No access to extra cash
  • No legacy from these assets

Pros of lump sum payout:

  • Ability to time distributions and access extra cash as needed
  • Protection against bankruptcy of pension provider
  • Inflation protection from market returns
  • Tax planning opportunities to realize income in certain years
  • Legacy - the ability to leave assets to family or charity
  • Ability to convert to a pension later if desired
  • Preferential charitable gifts after age 70 ½ from an IRA

Cons of lump sum payout:

  • Unreliable cash flows
  • Market risk
  • Potential of outliving your assets

Calculate the 'Richness' of Your Pension

Even if you're leaning toward a given strategy, you'll first want to calculate the richness of your pension payouts. First, review the income stream being offered by the pension plan, relative to a single premium immediate annuity (SPIA) that you could purchase with the lump sum you are being offered. If the payout from the annuity is relatively close to what the pension is offering. the pension payment would not be considered "rich". This is the first gauge of determining how competitive the company's pension payout is. As we proceed to the next step in the evaluation, use the pension option (pension from your company or immediate annuity from an insurance company) that provides the highest income amount.

As part of this first calculation, you'll have to choose between either a single life expectancy or joint life expectancy option. If you're single, the option is obvious. If you're married, you'll want to gravitate towards the joint life expectancy factor so the income stream continues for the longer of your joint life with your spouse, unless there are extenuating circumstances. These may include your spouse being in poor health or being significantly older than you. If you're single, but marriage is a consideration, you'll want to review the pension discussion with that in mind. Once a decision is made to use either single life or joint life, the decision is irrevocable.

The next step is to calculate the internal rate of return (IRR) of the monthly income stream over your life expectancy. You'll first need to determine your life expectancy. Use either a single life expectancy table or joint life expectancy table, based on the above discussion. Although certain factors can be analyzed in determining if you'll live longer or shorter than the average person, the actuarial tables are a great starting point in gauging your life expectancy. Utilize a Savings Distribution Calculator to solve for the IRR. Enter the lump sum balance offered from the pension plan, your life expectancy factor from above, and the monthly income stream of the pension or SPIA and solve for the rate of return.

Guidance: Outlook, Rate of Return and More

If your internal rate of return (IRR) is greater than 6% this indicates a very "rich" pension payout. It would be very difficult to find an investment that would provide a 6%+ rate of return with no market risk. If the IRR is less than 4%, we consider this a relatively modest return and you would have a high probability of exceeding this return with a balanced portfolio. If you're between 4% and 6%, you have to review the pros and cons listed above, as well as other factors in your personal situation before making a decision. These other factors may include your risk tolerance, your desire for consistent income, desire to leave a legacy to children or charity, desire for inflation protection, ability to do tax planning, flexibility in accessing additional funds, etc.

Important Considerations

The single life annuity payout will be higher than a joint life annuity, so there is a tendency to want to take the first option. If you're married and choose the single life annuity, you run the risk of dying before your spouse and leaving them without sufficient income. In this scenario, the payments stop at your death and your spouse would have no access to future payments. If you are in a long-standing relationship but not married, your only option is to choose the single life option. The benefit will die with you and is not available to a partner. If you marry after the annuity has begun, you cannot change the life expectancy option.

If you have had difficulty saving and spending within your means while working, and frequently spend a majority of your income, you'll want to give strong consideration to the life-time income stream of the pension, regardless of the IRR. In this scenario, even if you spend 100% of your assets, you can be assured the annuity check will arrive each month until you and/or your spouse pass away.

Electing the lump sum option offers you the flexibility to do more tax planning. A lump sum allows you to choose when and how much to withdraw from the IRA that ultimately will accept the pension lump sum. If you're in a relatively low tax bracket in a given year, you have the ability to either withdraw a portion of the account or facilitate a partial Roth conversion but stay within your designated tax bracket. This strategy can be used effectively to lower the lifetime taxes you will pay.

For those who want to leave a legacy, the lump sum option provides great opportunity. You have full access to the funds while you're alive. If your spouse outlives you, they will have full access to your IRA during their lives. If there is still money left when they pass, the remaining funds can go to your children in the form of an inherited IRA. In this scenario, your children must take minimum distributions, but they can extend those distributions over their lifetime. You have effectively maximized the benefits of tax deferral over two generations (or more).

The good news is that even if you elect the lump sum option, but later decide you'd rather have a guaranteed lifetime stream of income, you can purchase an immediate annuity with all or part of your lump sum. Note: Depending on the richness of the pension, an immediate annuity may not offer as large of a payout as the original pension.

Although there may not be a perfect right or wrong answer to this question, there is a strong framework you can follow to make an informed decision based on your goals and objectives. Many happy returns.

Kevin M. Reardon, CFP, is president of Shakespeare Wealth Management.