Selecting The Best Pension Payout Option
When you retire and turn on your pension, you typically have to make a decision as to how you would like to receive your benefits which includes making a decision about the survivor benefits. Do you select….
Lump sum
Single Life Benefit
100% Survivor Benefit
50% Survivor Benefit
Survivor Benefit Plus Pop-up Election
The right option varies person by person but some of the primary considerations are:
Marital status
Your age
Your spouse’s age
Income needed in retirement
Retirement assets that you have outside of the pension
Health considerations
Life expectancy
Financial stability of the company sponsoring the plan
Tax Strategy
Risk Tolerance
There are a lot of factors because the decision is not an easy one. In this article, I’m going to walk you through how we evaluate these options for our clients so you can make an educated decision when selecting your pension payout option.
Understanding The Options
To give you a better understanding of the various payout options, I’m going to walk you through how each type of benefit works. Not all pension plans are the same, some plans may only offer some of these options, others after all of these options, and some plans have additional payout options available.
Lump Sum: Some pension plans will give you the option of receiving a lump sum dollar amount instead of receiving monthly payment for the rest of your life. Retirees will typically rollover these lump sum amounts into their IRA’s, which is a non-taxable event, and then take distributions as needed from their IRA.
Single Life Benefit: This is also referred to as the “straight life benefit”. This option usually offers the highest monthly pension payments because there are no survivor benefits attached to it. You receive a monthly payment for the rest of your life but when you pass away, all pension payments stop.
Survivor Benefits: There are usually multiple survivor benefit payout options. They are typically listed as:
100% Survivor Benefit
75% Survivor Benefit
50% Survivor Benefit
25% Survivor Benefit
The percentages represent the amount of the benefit that will continue to your spouse should you pass away first. The higher the survivor benefit, typically the lower your monthly pension payment will be because the pension plans realize they may have to make payments for longer because it’s based on two lives instead of one.
Example: If the Single Life pension payment is $3,000, if instead you elect a 50% survivor benefit, your pension payment may only be $2,800, but if you elect the 100% survivor benefit it may only be $2,700. The monthly pension payments go down as the survivor benefits go up.
Here is an example of the survivor benefit, let’s say you elect the $2,800 pension payment with a 50% survivor benefit. Your pension will pay you $2,800 per month when you retire but if you were to pass away, the pension plan will continue to pay your spouse $1,400 per month (50% of the benefit) for the rest of their life.
Pop-Up Elections: Some pension plans, like the New York State Pension Plan, provide retirees with a “Pop-Up Election”. With the pop-up, if you select a survivor benefit which provides you with a lower monthly pension payment amount but your spouse passes away first, thus eliminating the need for a survivor benefit, your monthly pension payment “pops-up” to the amount that you would have received if you elected the Single Life Benefit.
Example: You are married, getting ready to retire, and you have the following pension payout options:
Single Life: $3,000 per month
50% Survivor Benefit: $2,800 per month
50% Survivor Benefit with Pop-Up: $2,700 per month
If you elect the Single Life option, you would receive $3,000 per month, but when you pass away the pension payments stop.
If you elect the 50% Survivor Benefit, you would receive $2,800 per month, but if you pass away before your spouse, they will continue to receive $1,400 for the rest of their life.
If you elect the 50% Survivor Benefit WITH the Pop-Up, you would receive $2,700 per month, if you were to pass away before your spouse, your spouse would continue to receive $1,350 per month. But if your spouse passes away before you, your pension payment pops-up to the $3,000 Single Life amount for the rest of your life.
Why do people select the pop-up? It’s more related to what happens to the social security benefits when a spouse passes away. If your spouse were to pass away, one of the social security benefits is going to stop, and you receive the higher of the two but some of that lost social security income could be made up by the higher pop-up pension amount.
Marital Status
The easiest variable to address is marital status. If you are not married or there are no domestic partners that depend on your pension payments to meet their expenses, then typically it makes sense to elect either the Lump Sum or Straight Life payment option. Whether or not the lump sum or straight life benefit makes sense will depend on your age, tax strategy, income need, if you want to preserve assets for your children, and other factors.
Income Need
If you are married or have someone that depends on your pension income, by far, the number one factors becomes your income need in retirement when making your pension election. If the primary source of your retirement income is your pension and you were to pass away, your spouse would need to continue to receive all or a portion of those pension payments to meet their expenses, you have to weigh very heavily the survivor benefit options. We have seen people make the mistake of electing the Single Life Option because it was the highest monthly payout and then the spouse with the pension unexpectedly passes away at an earlier age. It’s a devastating financial event for the surviving spouse because the pension payments just stop. If someone were to pass away 5 years after leaving their company, they worked all of those year to receive 5 years worth of pension payments, and then they just stopped.
We usually have to run projections for clients to answer this question, if the spouse with the pension passes away will their surviving spouse need 50%, 75%, or 100% of the pension payments to meet their income needs? In most cases it’s worth accepting a slightly lower monthly pension payment to reduce this survivor risk.
Retirement Assets Outside Of The Pension
If you have substantial retirement savings outside of your pension like 401(k) accounts, investment accounts, 457, IRA’s, 403(b) plans, this may give you more flexibility with your pension options. Having those outside assets almost creates a survivor benefit for your spouse that if the pension payments were to stop or be reduced, there are other retirement assets to draw from to meet their income needs.
Example: You have a retired couple, both have pensions, and they have also accumulated $1M in retirement accounts outside the pension, if one spouse were to pass away, even though the pension payments may stop or be reduced, there may be enough assets to draw from the outside retirement accounts to make up for that lost pension income. This may allow a couple to elect a 50% survivor benefit and receive a higher monthly pension payment compared to electing the 100% survivor benefit with the lower monthly pension payment.
Risk Management
This last example usually leads us into another discussion about long-term risk. Even though you may have the outside assets to accept a higher monthly pension payment with a lower survivor benefit, should you? When we create retirement plans for clients we have to make a lot of assumptions about assumed rates of return, life expectancy, expenses, etc. But what if your investment accounts take a big hit during the next recession or a spouse passes away much sooner than expected, accepting a lower survivor benefit may increase the impact of those risks on your plan. If you and your spouse are both able to elect the 100% survivor benefit on your pensions, you then know, that no matter what happens in the future, that pension income will always be there, so it’s one less variable in your long-term financial plan.
While this could be looked at as a less risky path, there is also the flip side to that. If you lock up the 100% survivor benefit on the pension, that may allow you to take more risk in your outside retirement accounts, because you are not as dependent on those accounts to supplement a survivor benefit depending on which spouse passes away first.
Age
The age of you and your spouse can also be a factor. If the spouse with the pension is quite a bit older than the spouse without pension, it may make sense for normal life expectancy reasons, to elect a larger survivor benefit. Visa versa, if the spouse with then pension is much younger, it may warrant a lower survivor benefit elect. But in the end, it all goes full circle back to the income need if the pension payments were to stop, are there enough other assets to supplement income for the surviving spouse?
Health Considerations / Life Expectancy
When conducting a pension analysis, we will typically use age 90 as a life expectancy for most clients. But there are factors that can alter the use of age 90 such as special health considerations and longevity. If the spouse that has the pension is forced to retire for health reasons, it gives greater weight to electing a pension benefit with a higher survivor benefit. When a client tells us that their father, mother, and grandmother, all lived past age 93, that can impact the pension decision. Since people are living longer, it increases the risk of spending through their traditional retirement savings, whereas the pension payments will be there for as long as they live.
Financial Stability Of The Company / Organization
You are seeing more and more stories about workers that were promised a pension but then their company, union, or not-for-profit goes bankrupt. This is a real risk that should factor into your pension decision. While there are government agencies like the PBGC that are there to help backstop these failed pension plans, there have been so many bankrupt pensions over the past two decades that the PBGC fund itself is at risk of running out of assets. If a retiree is worried about the financial solvency of their employer, it may give greater weight to electing the “Lump Sum Option”, taking your money out of the plan, getting it over to your IRA, and then taking monthly payments from the IRA. Since this is becoming a greater risk to employees, we created a video dedicated to this topic: What Happens To Your Pension If The Company Goes Bankrupt?
Tax Strategy
Tax strategy also comes into play when electing your pension benefit. If we have retirees that have both a pension and retirement accounts outside the pension plan, we have to map out the distribution / tax strategy for the next 10 to 20 years. Depending on who you worked for and what state you live in, the monthly pension payments may be taxed at the federal level, state level, or both. Also, many retirees don’t realize that social security will also be considered taxable income in retirement. Then, if you have pre-tax retirement accounts, at age 72, you have to begin taking Required Minimum Distributions which are taxable.
There are situations where we will have a retiree forego the monthly pension payment from the pension plan and elect the Lump Sum Benefit option, so they can rollover the full balance to an IRA, and then we have more flexibility as to what their taxable income will be each year to execute a long term tax strategy that can save them thousands and thousands of dollars in taxes over their lifetime. We may have them process Roth conversions, or realize long term capital gains at a 0% tax rate, neither of which may be available if the pension income is pushing them up into the higher tax brackets.
There are so many other tax strategies, long term care strategies, and wealth accumulation strategies that come into the mix when deciding whether to take the monthly pension payments or the lump sum payment of your pension benefit.
Pension Option Analysis
These pension decisions are very important because you only get one shot at them. Once the decision is made you are not allowed to go back and change your mind to a different option. We run this pension analysis for clients all of the time, so before you make the decision, feel free to reach out to us and we can help you to determine which pension benefit is the right one for you.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
