While Pensions Are Disappearing, Retirees Still Need Income

By David T. Mayes

While most companies have moved away from offering pensions as a retirement benefit for employees, some baby boomers nearing retirement still have these plans available and will need to make important decisions about how best to use these funds to support their retirement goals. Deciding when to receive pension income plans and how to structure the payout given the options available are two of the key choices facing retirees with pension plans.

For married couples, the choices are a bit more complex and there may be strategies that can be used to maximize the joint income available from a pension by combining a specific payout option with life insurance. Like with most financial decisions, there is no one-size-fits-all approach. Making an "optimal" decision will depend upon individual circumstances and assumptions about life expectancies and future investment returns. Here are some of the factors to consider when making pension claiming decisions.

To start with the basics, a pension is a retirement benefit that is defined by a formula which generally bases the retiree's annual payout on a benefit factor multiplied by final average salary and years of service with the company. Because the income is guaranteed for life, pensions can help retirees guard against the risk of running out of money during retirement. On the downside, pensions may not incorporate a cost of living adjustment, exposing the retiree to inflation risk, and those who are not fortunate enough to live well into their retirement years will leave less behind for beneficiaries unless they opt for a pension payout that provides a benefit for their spouse or children.

Often, pensions can be taken as a lump-sum rather than an income stream. Some retirees might prefer this option if they have a shorter life expectancy to ensure that some funds are left behind for family members after their death. Those concerned about inflation may also prefer cash up front on the premise that a lump-sum invested during a period in which the stock and bond markets see good returns may support a larger income stream over time than the pension plan's annuity option. Future investment returns, however, cannot be guaranteed so a retiree choosing a lump-sum option is accepting the investment risk in the hope of reducing the impact that inflation will have on the purchasing power of the pension's guaranteed income stream.

Lump-sum pension payouts should approximate the present value of the pension's lifetime income payments. If the lump-sum is larger than the expected future income, taking the cash upfront is preferable. Whether the lump-sum exceed the expected income depends partly on how the company computes the lump-sum amount and partly on the retiree's, and his or her spouse's, life expectancy.

Pension plans also generally have several income options that can provide ongoing benefits to a surviving spouse, or even children.

Often the default for married pensioners is a joint and 50% survivor annuity which provides a base benefit to the retiree and guarantees that half of that benefit will continue to the surviving spouse until his or her death. This option will provide a smaller monthly income than a single-life payout that stops at the retiree's death. This is because the pension plan expects to make more payments under a joint life payout option than when a single life is involved in the calculation. So, retirees must decide, based on their unique circumstances, whether to forgo some monthly income in order to ensure that a spouse will continue to receive a pension after their death. If other resources are available or the retiree is confident about having a long life-expectancy, selecting the higher, single-life payout may be optimal.

For those in good health, it may be possible to maximize the pension benefit by selecting a single-life payout and still provide income for the surviving spouse by purchasing enough life insurance to replace the survivor annuity payout. Because the amount of insurance needed to approximate what the spouse would receive from the pension declines over time, the retiree can purchase a combination of term polices and a permanent policy such that the premiums also decrease over time. If the initial premium for the policies is less than the gap between the single and joint and survivor pension payouts, the couple can expect to receive more lifetime income under this strategy.

David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Agent at Three Bearings Fiduciary Advisors, Inc., a fiduciary financial planning firm in Hampton. He can be reached at (603) 926-1775 or [email protected].