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.
