The answer to the question: “Do I have to withdraw a lump sum or an annuity from my pension?” could be: “Yes”.
Sometimes it’s better to take the lump sum and use it to purchase your own annuity, which is a stream of monthly payments that typically lasts your entire life and often your spouse’s. Other times, you would be fine in accepting the annuity provided by your employer. Investing the lump sum yourself is often the riskiest option and may not be suitable for many retirees.
Traditional pensions, also known as defined benefit plans, promise workers a certain amount upon retirement (or a “defined benefit”). They have become less common in the private sector as companies have moved to 401 (k) and other defined contribution plans, where no benefits are guaranteed upon retirement. Defined benefit pension plans are seen as costly and riskier for employers because they have to provide monthly pension checks for the rest of their employees’ lives.
To reduce costs and transfer risk to retirees, companies sometimes offer lump sums instead of monthly checks. Lump sums can give retirees the freedom to invest or spend as they see fit, but it can also mean losing money to bad markets or bad choices.
The best option for you depends on the answers to two essential questions:
How healthy is the company providing the annuity?
1. How healthy is the entity providing the annuity?
Some pension funds are seriously underfunded. This is especially true for many multi-employer plans which are supposed to provide pensions to union members.
Your pension plan is required to provide you with annual updates on its financial well-being. You can also view the plan’s Form 5500, which reveals its financial status, on FreeErisa.com. Vital information can be found in Part III of Schedule B or MB, which lists current plan assets, current liabilities, and percentage funded. Ideally, the latter number will be close to or greater than 100%.
The Pension Benefit Guaranty Corporation can step in and take over failed plans from one or more employers, but people may not get all they are owed. In a single employer plan, the maximum annual benefit the PBGC pays to a 65-year-old is $ 67,295. In a multi-employer plan, payments are limited to $ 35.75 per month multiplied by years of service. For a 30-year-old employee, that only amounts to $ 12,870 per year.
“If you are afraid [a plan is] not having enough money in 20 or 30 years and you will not get your pension or you will get a significantly reduced pension, that can be a real reason to take that money now.“
Christine russell, TD Ameritrade
“If you’re worried that they won’t have enough money in 20 or 30 years and you won’t get your pension or get a drastically reduced pension, that may be a real reason to take that money now. Says Christine Russell, Senior Director of Retirement and Annuities at TD Ameritrade.
Another reason to take a lump sum on an annuity is if the annuity options don’t match your situation, Russell says. For example, you might want your spouse to continue to receive 100% of your monthly check after you die, but the options available are limited to 50% or 75%. Or you might want to take some of your pension in cash as an emergency fund and “annuity” the rest. If your pension doesn’t offer this option, you can take the lump sum, keep some in cash, and use the rest to buy a immediate fixed annuity from an insurance company that can send you monthly lifetime checks.
If you decide to buy your own annuity, you’ll want to make sure the insurer is financially sound and able to honor its promises to pay. Look for “A” ratings from rating companies such as AM Best, Moody’s, Standard & Poor’s, and Fitch. State guarantee associations will step in if an insurer goes bankrupt and cover annuities up to certain limits (typically $ 250,000), but you’ll want to avoid the hassle and delay associated with an insurer’s insolvency.
Additionally, some private companies choose to purchase annuities from an insurance company instead of making payments directly. These insurers are generally reputable, says Russell, but you should check the company’s ratings before accepting the annuity option.
2. Will I have sufficient guaranteed income to cover basic retirement expenses?
The longer a person lives, the more likely they are to run out of money and many people underestimate the longevity risk that they and their spouse face. A 65-year-old man will live to age 84 on average and a 65-year-old woman to 86.5, while a married couple at 65 has a 50% chance that a spouse will live to 92 years.
“I can say, ‘Well I think I’m going to live to age 85’, but what if I live to age 95? You really don’t know, ”says Russell.
Women are at particular risk of outliving their money because they live longer and often have less savings for retirement. Those who are married at the start of retirement generally outlive their husbands – often many years and sometimes decades. When spouses die, household income can drop because one of the couple’s two social security checks disappears.
“Men still do the majority of this retirement planning, but they are often unaware of what will happen to their spouse after they die.“
Christine russell, TD Ameritrade
Yet many women leave retirement planning to spouses who don’t pay attention to longevity issues, she notes.
“Men still do the majority of this retirement planning, but they often don’t know what will happen to their spouse after they die,” says Russell. “Paying this pension for life can be absolutely essential in order not to fall into poverty later in life.”
A good way to manage longevity risk is to make sure you have enough guaranteed income from Social Security, pensions, and annuities to cover your basic expenses, says Lewis Mandell, financial literacy expert and author of “Que do when I get stupid: Radically secure approach in a tough financial age. “
Having sufficient guaranteed income means that your basic standard of living does not depend on the performance of your investments, says Mandell. Additionally, our ability to make financial decisions tends to decrease with age, which can make us more vulnerable to financial abuse, fraud, and poor investment decisions that could wipe out our chicken eggs. A guaranteed income can keep the lights on and the fridge full no matter what happens to our other assets, he says.
People trying to decide between a lump sum or an annuity often focus on whether they could earn more by investing the lump sum, Russell says. But in retirement, people should move from an “accumulator” mindset of maximizing their returns to one focused on mitigating risk.