Pension Planning Advice
Updated: Jan 20
When looking for pension planning advice there are many different factors to take into consideration. To start, is the pension a government pension or a non-government pension? Does the pension ever pay out a higher rate in the future or is that it? Does the pension offer a lump-sum distribution option and when does it make sense to take that? Will the pension pay out to a second person after the primary owner dies? There are so many things to consider as we go through the many variables.
What Pension Planning Advice Should You Seek?
The best pension planning advice you should seek is advice that is specific to your type of pension. Because of the many different pension options and implications, seeking out individuals that know your plan is important. In addition, looking for pension planning advice from an Accredited Investment Fiduciary is something we would recommend so that you are given objective advice that is catered around your specific needs.
Two Key Decisions to Make with your Pension Planning Advisor:
The two main decisions you will make with your pension planning advisor are what pension option should you select and when to take your pension. These are the two critical areas to start with while other decisions will also factor in the future.
What Pension Option Should You Select
The first key decision to make with your pension planning advisor is what pension option you should select. In order to start this discussion, you will want to know what pension options you have available to you. Most commonly, options to be decided upon involve options such as single life, joint life, or a partial blend of the two. In addition, do you want a certain amount guaranteed to pay out over a specific time frame should you pass away. Last, do you have the option of taking a lump sum distribution or a partial distribution and how does that impact future payments.
When To Take Your Pension
The second key decision to make with your pension planning advisor is when to take your pension. It is commonly seen that the longer you wait, the larger the benefit but this is not always the case. There are other factors that can actually reduce the pension benefit after separation from the employer.
How Do Pension Plans Work?
Pension plans are a type of defined benefit plan offered by some employers. The overall concept of a pension is that the employer sets aside a certain amount of money each year in order to cover a future benefit for the employee. The employee may be also required to contribute a certain percentage of their wages each year. When the employee retires, the pension is intended to replace a certain percentage of that employee’s former wages. That payment is typically made for the life of the employee and perhaps longer based on the options available.
Income Vs Pension Buyout
Should you take the income stream a pension offers, or is it better to select the pension buyout option where you can cash out a portion or all of the pension? To start, how much money is being offered in a one-time payment vs. the ongoing income payment.
Example: Single Life Monthly Payment - $2500 vs. Lump Sum Distribution - $1,000,000.
Once you have both of these options, it is possible to then determine the percent of that lump sum number that is being distributed each year known as a withdrawal rate.
Example: Single Life Annual Payment - $30,000 divided by Lump Sum Distribution - $1,000,000 = 3% The question then becomes, would it be possible to elect the lump sum distribution, distribute the same amount to yourself monthly, and still grow the money enough to not run out in your lifetime.
How much is a good pension withdrawal rate?
Withdrawal rates and whether they work for your situation partially depend on the length of time the money is needed. If you know how long you will live, you can make a more exact decision, but for most people we aim for a conservatively long enough time based on actuary tables. Some research published has shown that a 4% withdrawal rate is a sustainable number over an average 65 year old retirees lifetime. If you retire earlier, a lower number is needed, and if you retire later, a higher number could work.
Withdrawal rates are also impacted by current interest rates. If it is possible to invest the money into investments that consistently and predictably pay out rates that are above 4%, it would make sense to be able to accept a higher withdrawal rate.
Example: The pension options for a 65 year old are to take a $500,000 lump sum distribution, or to take $2500 per month for the rest of their life. By dividing $30,000 by $500,000 we determine the withdrawal rate is 6%. Under normal circumstances, the 6% offered by the monthly income is greater than what the $500,000 could sustain, so taking the income would be reasonable. However, if bank CD’s are offering to pay 7% due to higher than normal interest rates, you could consider a higher withdrawal rate on your investments.
What other factors are used in deciding income vs. pension buyout?
There are a number of additional factors that can come into individuals unique situations that may impact your pension planning advisor’s recommendation. The first factor is your health. Pension income streams are more beneficial for people that have longevity in their future. And if you are a woman, there is a greater chance of longevity as compared to your male counterpart.
Another factor to consider are cost of living adjustments (COLA). A COLA is whether or not the pension income will increase in the future once the benefit begins to distribute the funds. If there is a provision for a COLA, what are the terms and the history of it occurring? Some COLAs may require board approval and can be 0% in some years, while others have percent minimums that it is required to increase.
A third factor to consider are interest rates. This fact may surprise you, but if interest rates go up in the future, it can impact your lump sum payout amount and cause that to go down. In the same way, if interest rates go down, that could do the opposite and offer a greater lump sum benefit. The good news is that your payment for life option is not impacted directly by interest rates.
When Should I Begin Taking My Pension?
When you should begin taking your pension depends on several factors. To start, have you analyzed the different options available and you know which one is best for your situation? Next, do you know how your pension works and understand what starting it at different ages will mean? Most pensions accumulate the most during the last years of employment due to the fact that your wages are frequently the highest they’ve been at this time. If taking the pension a year early means a 15% reduction in benefits, would that be ok?
The next factor to consider if whether you have put together a retirement tax plan. If you haven’t, you will want to know the tax implications upon taking the pension and how that could affect your Social Security benefits or the amount to convert from a pre-tax account into Roth. Another factor to consider is if the pension also allows for the portability of healthcare? For example, if you can take a pension at 62, but will be without health insurance for a couple years before Medicare, do you have a plan and a budget for that? And finally, have you looked at the pension in light of your retirement plan to determine that the amount being paid out is enough to allow you to retire in the lifestyle you’ve become accustomed to? If all those things are “yes”, then the answer could be “Now!”.
What about Pension Taxes?
Pension tax planning on the surface can seem like a straight forward situation. If you take a lump sum distribution from a pension and move that into a tax-qualified account like an Individual Retirement Account (IRA), there is no tax due at that time. If you take the monthly income from the pension, that income is taxed as ordinary income and you are paying taxes similarly to when your employer was paying you that money.
How tax planning for pensions becomes more complicated are primarily in two situations. First, if you take a lump sum or partial distribution from the pension, the tax planning can be more complicated than just whether to withdraw the money or leave the money in the account. Instead, there is a third option where you convert some of the money into a Roth IRA yearly.
The next situation that offers additional complications are when people take a pension but do not consider the implications on other areas of their lives. If someone is taking Social Security and then turns on income from a pension, that pension may not be taxed any differently, but it can change the amount of your Social Security benefit that is going to be taxed. Similarly, pension income if on Medicare can change the cost of Medicare part B, and that income could cause a higher Medicare premium due.
Due to the many faceted considerations in these situations, these kinds of strategies are best done in light of a full retirement plan where you can see how everything works and integrates into one another.
Common Pension Distribution Options
When to Use
Single Life Annuity
Joint and Survivor Annuity
Life with Accelerated Payments
Defined Benefit Plan
The most common type of pension and the one we most frequently reference is the defined benefit plan. Just like the name says, ultimately there is a defined benefit offered for a defined amount of work and wage. A defined benefit plan is just what the name says – a defined benefit. The terms of these plans state that if you work for a company for a certain amount of time, and make a certain amount, when you leave the company will replace a certain portion of your earnings. In these plans, the burden is on the company because they have to grow the money added to the account over time to be able to support that payment for life – no matter what happens in the stock market. That can be a hard task, which is why companies have moved away from defined benefit pension plans.
Cash Balance Plan
Cash balance plans are a different flavor of defined benefit plans. They are plans that look more like a 401k profit sharing plan, but the company is required to fund them each year unlike a profit sharing plan. Each participant of the cash balance plans gets an amount credited to their account each year as a pay credit for their work, and an interest credit applied to the balance. These plans often have no monthly payout at a certain age but are designed to offer a cash balance to move to an IRA when it becomes available. These kinds of plans can be very beneficial for high earning business owners who are older or have a young staff and they want to put away as much money in retirement accounts as possible.
FAQ’s What is a Pension Buyout?
A pension buyout is when a company decides to discontinue a pension and they offer a lump sum payment to all participants as a way for them to get money from the plan sooner. Mostly commonly, pension buyouts are offered on pensions that did not have a lump sum so this is a way for the company to offer that option and ideally pay out all the funds so they no longer have administration and upkeep around the plan.
Pension planning advice can be complicated because each pension can be slightly different than the next, and everyone’s person situations are unique and what makes sense for one person may not be the best choice for the next. It is always wise to consult a professional before making a final decision to ensure that the strategy you choose fits with your financial plan.
We are happy to help with coordinating assets and analyzing the break even so that you can make an informed pension planning decision. If you have questions about this, reach out and contact us and we are happy to help.