What is a Pension Plan and How Does it Work?
You may be wondering… what is a pension plan and how does it work? A pension plan is a retirement plan that requires an employer to make contributions to investments set aside for a worker’s retirement. Once employees retire, they are given multiple options; they can choose to receive a lump sum when they retire or receive regular payments for life through an annuity.
There are two types of pensions covered by the Employee Retirement Income Security Act: Defined benefit and defined contribution. Defined benefit plans are funded with money your employer contributes and provides you with a set payout when you retire. A defined contribution plan, such as a 401(k) or 403(b) requires you to contribute your own money. Most companies today favor the latter for obvious reasons, less money out of their pockets.
There are two primary versions of defined benefit plans: traditional pensions and cash-balance plans. If you meet basic eligibility rules and have been in the job for the specified amount of time, you’re automatically enrolled in the plan. You also need to have been employed long enough based upon your company’s requirements to be fully “vested” in the plan (for many this period is 5 years). These two plans differ in how the benefits are calculated; pensions are based on a formula that factors in how long you were on the job and your average salary during your last few years of employment. These types of plans are also not portable. The cash-balance plan credits your account with a set percentage of your salary each year and has a portability component as you can take it as a lump sum and roll it into an IRA. Some traditional defined benefit plans are protected up to a certain limit by the Pension Benefit Guaranty Corporation (PBGC). You can learn more on PBGC’s website.
While pension plans seem quite desirable, there are drawbacks:
They are managed by the employer, not you. You have no say in how the plan’s investments are being managed, nor do you have any control over how adequately these plans are financed.
Due to the cost of maintaining these plans, your benefits may be cut or frozen during times of economic hardship (for some, there is protection afforded by the Pension Benefit Guarantee Corporation, but the amount is not guaranteed to cover your total loss).
According to the U.S. Department of Labor, there are hundreds of pension plans across the country that are underfunded and in danger of being unable to meet their pension obligations.
Understand the Choices
If you choose your pension plan’s monthly lifetime payment option, that means you’ll get a benefit check every month for the rest of your life after you retire. The monthly benefit will always be the same. For example, if your monthly lifetime payment is $2,000, then you’ll get $2,000 each month. You do need to pay taxes on your pension payments. Years of service, final average salary and a benefit multiplier (usually between 1% to 2%) are taken into account when determining the amount.
The lump-sum payment is when you receive one large cash payment from your pension plan instead of receiving your pension in monthly installments. Essentially, it is your company buying you out, so they are off the hook for any future obligations. Your salary, current age, life expectancy and interest rates set by the IRS are some of the data employers use to figure out what to offer you in a lump sum.
So, if you are the recipient of a pension, how do you decide whether to take a lump-sum buyout or lifetime payments?
Do the Math
Calculate the internal rate of return (IRR) using an online calculator. Enter the lump sum as a negative cash flow and the pension payment payout as positive cash flow. Use the joint life payout if you are married and the straight life if you are single. What does this number tell you? You’d have to generate a return of whatever that percentage is on your lump sum each year in order to match what your pension would pay over the course of that same time period. The longer you live, the greater the return on your pension, and the higher the return you’d need to generate yourself with your lump sum to match it. It is also important to know your break-even point, as you will need to know how long it will take to get the full lump sum amount if you opt for the pension payment option.
Review Both Sides of the Equation
Inflation leads to loss of purchasing power. If you opt for the pension lump sum payout, ensure it aligns with your standard of living or ensure there are other assets in the stock market that are growing to keep pace with inflation. You may be lucky enough to have a pension that provides inflation-adjusted income, which will help remedy the issue as well.
Having access to a lump sum can be problematic for some. If you are prone to spending and don’t have a high level of will power, the pension payments may be a better choice.
Pensions fall outside your estate for inheritance tax purposes, which means they can be a valuable tool for passing money to heirs and limiting taxes. However, not all pension savings can be passed on to heirs. With a defined benefit or salary pension, your heirs may receive dependents’ benefits but will not inherit any of the savings. Most pension payments stop after the death of the employee or the death of a surviving spouse, and there’s no opportunity to designate beneficiaries. If leaving a legacy is important to you, you may want to consider a lump sum distribution with a direct IRA rollover, so your kids can inherit the savings. A popular workaround if you want to opt for the pension payments is pension maximization, which is buying life insurance with the straight-life pension payout. The straight-life pension payout provides the most income, but the income stops at death. The extra payments from the straight-life pension buy life insurance. The life insurance death benefit is a substitute for the lost pension income at death. This is not an issue with defined contribution pensions, self-invested personal pensions, or stakeholder pensions. Beneficiaries inherit the full savings with these plans.
Knowing which option is right for you can be difficult to determine on your own. Discussing this with a fiduciary can give you the peace of mind you are making a wise decision. Please contact us at (410) 840-9200 if you’d like to discuss your options.
Kiplinger. (December 2021). Should You Take Pension Payments or a Lump Sum? A How-To-Guide.
Retireguide. (February 2021). What is a Pension?
Moneyweek. (August 2021). Inheritance tax planning: how a pension can shield your estate from inheritance tax.
Forbes. (July 2021). Take the Lump Sum or the Monthly Pension?
Main Street Advisors, LLC. March 2022. Main Street Advisors, Inc. is a Registered Investment Advisor. The articles and opinions expressed in this material were gathered from a variety of sources, but are reviewed by Main Street Advisors, LLC, prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of March 2022 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual situation. Always contact your financial/investment professional before making any financial decisions. Main Street Advisors, LLC is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.