Monthly Pension or Lump Sum Benefit?

More and more retiring employees are facing the question of whether to take their retirement benefits as a lump sum payment or a life-time monthly payment. The “correct” decision obviously lies with the individual’s particular circumstances (health of retiree and spouse, other financial assets, fund needs, etc.). There are compelling reasons for both scenarios in today’s interest rate environment. Monthly pensions usually come from employer sponsored defined benefit plans. Such pensions are “guaranteed” by the employer as long as the employee (and/or possibly another beneficiary) is alive. Following death, all benefits cease. The lump sum option represents a current payment of all future retirement benefits offered by the employer; the employer’s obligation ceases with the lump sum payment.

Monthly pension amounts are usually based on formulas established by the benefit plan. Common conditions include length of employee service with the company and the highest annual earnings of the employee for a specified number of years. This type of plan is just what the name implies: a defined benefit. The employer is guaranteeing the retiree an income for the rest of the retiree’s life. Therefore, the employer is responsible for providing contributions into the retirement plan that will sustain anticipated benefits for all employees and retirees of the company over their lifetimes. The employer also bears the investment risk for plan assets. If the plan assists earn more than projected, less money can be contributed to the plan. If the plan assets earn less than projected, the employer must increase contributions to the plan.

Each choice offers advantages and disadvantages which we will discuss below.

Monthly Pension

When a retiree elects the monthly pension option, there are several payment offerings available. The amounts differ depending on the actuarial assumptions involved. The retiring employee may select a single life payment (for the life time of the retiree only), a joint and survivor payment (where monthly payments continue as long as the retiree or a designated beneficiary is alive), or an option for payment over a certain time period (which guarantees payment for life time but also for a minimum specified period). The obvious benefit is a steady source of monthly income. However, inflation may erode the value of monthly payments depending on the cost of living adjustments (if any) to the monthly benefit. In addition, the retiree is depending on the strength of the plan to maintain payments over a retirement lifetime.

Lump Sum Payment

With a lump sum payment, all retiree benefits are given to the retiring employee at retirement. The retiree is now responsible for investing the benefit payment in such a way that the monthly income checks are duplicated. The length of time such payments continue is purely dependent on how successfully the investments perform. The investment risk has been shifted from the employer pension plan to the retiree. In exchange for that risk, the retiree gains a significant opportunity. While payments stop at death for monthly pensions, retirees with a lump sum option may have assets remaining which they can pass to heirs of their choice.

Lump sum payments are based on an assumed earning rate over the retiree’s lifetime. The higher the assumed earning rate, the lower the amount that needs to be distributed as a lump sum payment. Conversely, the lower the assumed earning rate, the greater the amount that needs to be distributed as a lump sum. Today’s low interest rates favor larger lump sum payments.

Why are employers offering the lump sum option?

The primary reason for a lump sum option is the shifting of responsibility for future benefits from the employer to the retiree. Many retirement plans today are underfunded; i.e. the plan does not have enough assets to meet the expected liabilities of current and future retirees. The lump sum payment removes any further obligation from the employer.

Employers also pay an annual premium to the Pension Benefit Guaranty Corporation for each employee covered by the plan. This premium is made to guarantee that the retiree will receive some (not necessarily all) retirement benefits if the employer’s plan fails. The current premium (for 2014) is $49 per employee; it is rising to $64 per employee in 2016. That increase will likely continue as the premium payments are tied to inflation in the future. Reducing the employees covered by a plan also helps reduce overall plan expenses.

What to Do?

As mentioned earlier, this retirement election is critical to a successful retirement. We at Paragon Financial Advisors will assist in analyzing the benefits available under retirement plan options to ensure that the choice matches the best interest of the retiree. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

IRA Changes

Individual Retirement Accounts (IRAs) have been a popular savings vehicle for a long time (since 1974). They became more popular with the Economic Recovery Tax Act of 1981. Contributions made into an IRA were usually tax deductible (depending on your income level) and grew tax deferred until money was taken from the IRA. There were contribution limits (the smaller of 15% of taxable income or $1500 in 1974 and $5500 today for those under age 50). There are also penalties if the money was withdrawn before age 59 ½. No taxes were due on the earnings until payments were taken from the IRA; that payment was then taxed as ordinary income. There was also a “required minimum distribution” (RMD) at age 70 ½. Failure to withdraw your RMD was subject to a 50% penalty plus ordinary income tax on the amount that should have been withdrawn.


Since contributions were limited, one would think that IRA accounts have modest account values. However, rollovers from corporate benefit plans have been allowed. Such rollovers did not result in a taxable distribution from the benefit plan to the employee, and the rolled amounts could continue to grow tax deferred. The net result is that significant amounts (trillions) of dollars are now contained in IRAs. There have been some recent changes in IRA laws which warrant planning consideration. We discuss some of those below.


Asset Protection

In many states, IRAs were protected assets; i.e. they were not subject to attachment by creditors as long as the IRA was established under the Employee Retirement Income Security Act (ERISA). Such plans had an anti-alienation provision which prevents an employer or plan administrator from releasing benefits to a creditor. In July, 2014, the Supreme Court of the United States ruled that “inherited” IRAs were not protected from creditors. An IRA passed to a non-spousal heir was not protected because the non-spousal owner: 1) could not add to the account, 2)had immediate access to the entire account without penalty, and 3) was required to take annual distributions from the IRA regardless of age. There are still state considerations which may come into play, but the case does show that IRA creditor protection is worthy of planning.

Exemption from Required Minimum Distributions

As previously mentioned, IRAs are subject to a required minimum distribution at age 70 ½. However, there is an exception to that rule. An exemption is given to funds put into a deferred annuity. The IRA owner can purchase an annuity and defer the start of benefit payout until age 80. The purchase amount is limited to the smaller of 25% of the IRA or $125,000. That annuity is excluded in the calculation of the annual RMD amount. The basic intent was to allow the individual to provide guaranteed income protection later in life from the IRA holdings. While such a plan provides protection from minimum distribution requirements, the economic advisability warrants another complete analysis.

Temporary Withdrawals

Currently an IRA owner is allowed to withdraw from an IRA with no tax implications if the total amount withdrawn is replaced into the IRA within 60 days. Such a withdrawal is allowed once every 12 months and can be done from each IRA account. For example, an individual with two IRA accounts could do two such withdrawals and replacements every 12 months with no income tax consequences. That rule will change beginning in January, 2015. After that date, an IRA owner can make only one temporary withdrawal within 12 months from IRA accounts—regardless the number of accounts.

We, at Paragon Financial Advisors, assist our clients in management of their IRAs. If you have questions or concerns about your particular situation, please call us.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Paragon Perspectives

Retirement brings many changes. The old adage of “twice as much spouse and half as much money” is humorous; other aspects of retirement are not. In this issue, we discuss some of the planning issues that retirement brings. We also look at what may lie ahead for rising interest rates.


The first article discusses longevity. No one knows how long they will live, but prudent planning says “run out of time before you run out of money.” There are some things that we can do to plan for an extended life span. Three are discussed in the first article.


The second article explores financial issues surrounding the  death of the first spouse. In many households, one spouse is the primary financial manager. If that spouse dies first, the remaining spouse may be faced with financial decisions at an obviously stressful time. What can be done to remove some of the financial stress? That is the topic of discussion in article two.


Finally, how long can these low interest rates last? No one knows for sure—even the Federal Reserve Board of Governors. However, there are some historical items that might give a clue. The third article shows the historical difference between the rate of inflation and the 10 year U.S. Treasury bond. Looking at the current “spread rate” might provide some indication of what lies ahead.


Sincerely,


Wm. Jene Tebeaux CFP® CFA® CAIA®



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