Are You One of the Few With a Traditional Pension Plan?

Pension

If retirement is closing in quickly and you have a defined benefit pension plan (for example, you receive $2000 per month for life at retirement from your company), how you claim that pension will have lasting consequences on your retirement and estate plans. Literally, hundreds of thousands of dollars may be on the line.


The common claiming options

The most common options for claiming a defined benefit pension are: single life, joint 50%, joint 100%, and a lump-sum option. The choice that makes the most sense for you depends on both your situation and your preferences.

The single life option is just as it sounds – once the pension recipient dies, the income stream stops. If you are married, this is most likely unpalatable for your spouse; enter the joint 50% and joint 100% options. Typically, joint 50% pays around 70-90% of the single life payment amount, and joint 100% around 60-80%. Payout percentages are plan specific – you’ll have to look up the numbers as they apply to your plan.

The joint options continue payments once the original pension recipient dies. The drawback is that the pension amount is reduced compared to the single life option, and in the case of the joint 50% pension, the spouse only gets half of the original amount. Additionally, if both spouses die simultaneously or in quick succession, especially if this happens during the first few years of receiving the pension, much of the pension benefit will go unrealized. Nothing is transferred to the people and causes you care about.


What if I want to retain the full value of the pension regardless of what happens?

Most pension plans have a lump-sum option. Whether this option makes sense to you depends on the ratio of the annual pension payout to the lump-sum. As a rule of thumb, if the lump-sum is at least 20 times the annual payment, it is an easy choice to take the lump-sum. Below this level, other considerations start coming into play. At anything less than 10 times the annual payment, unless there are extenuating circumstances, taking the pension stream is a given.

The other case to be made for a lump-sum payout is removing the money from the plan. The plan is only viable so long as it is funded. In recent years, there have been numerous cases where pension plans have failed, resulting in reduced payments to pension recipients (most plans are backed by Pension Benefit Guaranty Corp which takes over failed plans and pays a fraction of the original benefits). If you think there is a good likelihood that your pension plan might not be around in 10 years, you should strongly consider the lump-sum option.


What if I like the pension, but also want to leave money behind?

Enter pension maximization using life insurance. This strategy uses a combination of the single life benefit and life insurance. There are many ways to structure this strategy. I will illustrate the option which maximizes your protection and guarantees a death benefit for life. The insurance amount should be sufficient to replace the entire present value of the income stream. This way, regardless of when the pension recipient dies, the full value of the pension benefit will be realized. Of course, there is no such thing as a free lunch.

Insurance is rather expensive. This strategy will likely result in lower cashflow than the joint 100% option while payments are being made toward the insurance. Usually, the sweet spot for payment timeframe is around 15 years for a good mix of payment amount vs. timeframe for paying up the policy. For example, if you have a $50,000 per year single life pension, an appropriate amount of insurance would be $800,000 with a cost around $20,000 per year for 15 years for a guaranteed universal life policy that will cover you for life, if you’re in good health. This brings us to the next caveat.

Insurance requires underwriting. There is a chance that the policy will be cost-prohibitive, or that you do not qualify at all. The only way to find out is to apply. An important note here is that applying for insurance is non-binding. It is simply the first step for the insurance company to prepare an offer, which you can then choose to accept or decline. This step should be taken 2-3 months before the deadline for choosing your pension payout option, as it usually takes about a month to complete the underwriting process. The worst situation would be to be stuck with a single life payout with no insurance to back it!


What’s the best option for me?

Single and not looking to leave money behind:

If you are single and not looking to leave any money behind, the single life option will net you the highest pension benefit. For those looking to do gifting during their lifetime, the single life pension is likely the best option. Things get more complicated for those of us who are married, or if you want to create a legacy.

Married and not looking to leave money behind:

If you want to protect the income stream from the death of the pension recipient, but are not concerned with leaving a legacy, the joint options come into play. Whether you chooses joint 50% or joint 100% depends on the difference between pension amounts, and how comfortable you are with taking risk. The conservative option is the joint 100% option, and many people go this route. The lump-sum is also viable, if it is substantial enough.

Looking to leave money behind:

If you are interested in leaving some money behind, your best bet is either a lump-sum payout or the pension maximization approach.

With the lump-sum option you lose all guarantees that there will be money available at your death, but you do have full ownership and control over the money. If the lump-sum payment amount is large compared to the income stream, this is likely your best choice.

With the pension maximization strategy, you’ll have a guaranteed amount available to distribute to the people and causes you care about, but you won’t be around to see that gift through. Furthermore, for the period that you will be paying for the insurance policy, your take-home pension will likely be the lowest out of all of the options.


More questions?

As you can see, there is no single answer to “what is the best pension option?” It all depends on your goals and how the pension is structured. The only way to know which option is best for you is to analyze the options as part of a holistic financial plan. Financial choices never exist in a vacuum. Your finances are an interconnected network. Each part exerts a pull on the others. What you choose to do with your pension will affect your insurance coverage requirements, withdrawals from investment accounts, tax optimization strategies, and a host of other financial decisions.

If you are scratching your head about which way to go with your pension, we invite you to visit us. We’ll look at your options together, and come up with a plan that works for you.

 

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