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.
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.