Often the decision to take a pension annuity option over an available lump sum option is based on which option provides the highest income. And that makes perfect sense if all other factors related to this decision are excluded from the due diligence process.
But when you consider all the factors that go into this decision, choosing a pension annuity option over an available lump sum option becomes more a matter of control than payment amount.
Problems with pensions
Today we are seeing fewer pensions than 20 years ago, and there is a reason for this downward trend. The truth is that pensions are facing systemic problems, which is why we see private sector companies replacing these defined benefit plans with defined contribution plans, such as 401(k).
There was a time when employees worked until they physically couldn’t do their job anymore, and when they retired they died soon after. What we see today is employees retiring much earlier in the cycle and living longer, which translates into significantly higher pension costs that are simply unsustainable.
Speaking of sustainability, historically pensions have used 4.5% to 7.5% to calculate their benefit projection and with interest rates well below this range, it helps a lot to improve the outlook of the plans, but it does very little to change their actual solvency. .
Interest rates have been well below these percentages for decades, and when you combine that fact with a projected 10-year benefit period, you can see how the math looks great on paper. But the reality is that if someone retires at age 50 (which is often the case when it comes to a pension) and lives into their 70s and 80s, you can see that the 10-year estimates are not real.
Nearly 1 million working and retired Americans are currently covered by pension plans that are in imminent danger of insolvency, according to a 2017 report Daily News Article.
So what happens if a pension can’t pay promised benefits? According to The Heritage Foundation, the FDIC-like Pension Benefit Guaranty Corporation (PBGC) found that for a promised benefit of $24,000 a year, they are only insured up to $12,870.
To compound the problem, this insurance has the same problem as the FDIC. The FDIC has billions in reserves but has exposure to trillions of dollars in bank accounts. The same problem exists within the PBGC. The promise of insurance benefits is not mathematically supported. If PBGC goes bankrupt, that $12,870 pledge can actually only cover $1,500 under the insurance benefit.
The concern here is that when you retire and depend on an annuity payment from a pension, you are putting a lot of reliance on the pension calculations. And if the calculations are wrong, there is not enough insurance to recover the loss.
A lump sum gives you more control over your assets
I started this article by suggesting that the decision to accept a pension annuity payment instead of an available lump sum option is often based on which option provides the most income. But when you add it all up, the decision to accept a lump sum offer has more to do with control and preserve your future sources of income of what is the payment of the annuity that they promised him from the pension.
Now, I’m not suggesting that all pensions are destined to go bankrupt, but this possibility should be considered when structuring your sources of income that are designed to sustain you for the rest of your life.
By accepting a lump sum pension, you gain control over your income assets. Even if the income generated from the lump sum is less than the promised annuity payment of the pension, you gain control of the assets.
Even without the risk of a default, this lump sum option is an important factor when considering the following:
- Your income needs may fluctuate during retirement, and controlling the assets that support your income gives you the flexibility to meet your income needs.
- You are in a better position to care for your spouse if you predecease them by owning the assets and leaving them behind so your spouse can continue to earn income.
- Your heirs may be the beneficiaries of the estate after you and your spouse die when a pension is guaranteed to disinherit your heirs since it does not pass to your children. In some cases, a child could receive a part of the support that has not yet been paid.
- You have access to assets if there comes a time in your life when you may need cash, and having control over assets gives you that option.
If you must opt for an annuity, the single life option gives you more control
Of course, not all pensions have a lump-sum option, which means you have no choice but to accept an annuity payment. If that’s you, there are a few things to consider before selecting your irrevocable annuity option.
As with a lump sum, the idea is to put as much as possible into your control. It may be tempting to accept a reduced benefit to support a spouse or loved one after your death, but this option only gives the pension more control.
A single life annuity option is typically your highest monthly benefit and is the fastest way to get the most out of your pension in the shortest amount of time. The downside of choosing this option is that it may leave your spouse with a shortage of income because payments would stop after his or her death. Therefore, if you are married and decide to make this election, your spouse must sign that decision.
Therefore, you have two options to protect your spouse:
- You can take out insurance outside the pension. With this option, you would accept the single life benefit, taking the highest annuity payment and then paying a premium to an insurance contract that would pay a lump sum to the surviving spouse or children if you predeceased them. This approach also gives you the flexibility to cancel the policy if circumstances change and the benefit is no longer needed.
- Or you can buy insurance through the pension. In this case, you would opt for a joint and survivor annuity, choosing to accept a reduced annuity payment in exchange for the benefit continuing for your spouse if you predecease. Essentially, you are paying for insurance with your lower benefit amount. It is worth mentioning that this benefit only has one beneficiary, so you would disinherit your children if you choose this option.
The Hidden Costs of a Joint and Survivor Benefit
An important factor when choosing a joint and survivor annuity is the cost of purchasing the insurance through the pension. Of course, there are premiums in any scenario, but when buying into a pension, there are unique circumstances that most people completely overlook.
If your pension has a cost-of-living adjustment built in, you should recognize that because a joint and survivor benefit is lower, you will receive a lower cost-of-living increase than you would a single-life benefit, which means that the difference between what would be the maximum benefit and the reduced benefit worsens over time. That translates into an ever-increasing cost for inflation insurance.
A quick example of this: Let’s say you have a maximum benefit of $5,000 per month with a single life annuity and a reduced benefit of $4,000 per month with a joint and survivor annuity. That leaves you with a monthly insurance cost of $1,000 per month. When you factor in a 3% cost-of-living adjustment, that’s 3% on top of the benefit you receive. So 3% of $5,000 would be $150, while 3% of $4,000 would be $120, a difference of $30 per month. This income gap worsens over time. Projected over 20 years, the gap grows to more than $1,800 per month.
And if that wasn’t reason enough not to purchase pension insurance, consider the fact that the longer the pensioner lives, the fewer years the spouse receives pension insurance. When you think about it, buying pension insurance means you’re agreeing to a deal where you’re paying an increasing monthly premium for a decreasing benefit.
And unlike life insurance taken out outside the pension system, this spouse pension insurance is only extended to your spouse, unless you choose a child as beneficiary.
Now, if you opt for a single annuity and choose to buy insurance outside the pension system, it is essential that the type of policy you buy and the amount of insurance obtained are in line with what you need to protect your family. . One misstep in this process can leave your policy at risk of lapse or expiration, leaving your spouse vulnerable to a significant income gap.
To download my free guide that will walk you through the benefit determination process and the most appropriate type of life insurance to protect benefits, visit www.thepensionelectionguide.com.
Benefits and guarantees are based on the insurance company’s ability to pay claims.
Securities offered through Kalos Capital Inc., a member FINRA/SIPC/MSRB and investment advisory services offered through Kalos Management Inc., an SEC registered investment adviser, both located at 11525 Park Wood Circle, Alpharetta, GA 30005. Kalos Capital Inc. and Kalos Management Inc. do not provide tax or legal advice. Skrobonja Financial Group LLC and Skrobonja Insurance Services LLC are not affiliates or subsidiaries of Kalos Capital Inc. or Kalos Management Inc.
Founder and Chairman, Skrobonja Financial Group LLC
Brian Skrobonja is an author, blogger, podcaster, and speaker. He is the founder of St. Louis-based wealth management firm Mo. Skrobonja Financial Group LLC. His goal is to help his audience discover the root of their beliefs about money and challenge them to think differently. Brian is the author of three books, and his podcast Common Sense was named one of the top 10 by Forbes. In 2017, 2019, 2020, 2021 and 2022 Brian received the Best Wealth Manager award, in 2021 he received Best in business and Future 50 in 2018 from St. Louis Small Business.