Benefits of Lump-Sum Pension Options
The traditional pension plan for retirees, particularly in the private sector, is becoming a benefit of the past. The emergence of 401(k) plans over the past few decades has ushered in a shift in responsibility for retirement income from the employer to the employee. Pension plans are typically one of the largest liabilities on a company’s books, and many are looking for ways to ease those obligations in the future.
One way to accomplish their goals is to offer “lump-sum” options to plan participants. As the name indicates, “lump-sum” options offer a one-time payout of benefits in lieu of a stream of payments over time. The amount offered to participants is a discounted present value of what the total payments would have amounted to throughout retirement. Choosing a one-time payment versus a stream of payments is dependent on each individual’s personal circumstances, but in the current environment an upfront payment could be desirable for several reasons.
Low Interest Rates
Pension plan calculations are very complicated, and benefits are dependent on age, years of service, and level of income. However, one common factor to all pension calculations, whether lump-sum or stream of payments, is interest rates. When interest rates are low, as they are currently, one-time lump-sum options yield higher benefit amounts compared to the same circumstances at higher rates of interest. In theory, a retiree could opt for a one-time benefit payment and roll over the full amount to an IRA to avoid any potential immediate taxation. Within the IRA, the funds can be invested according to the individual’s specific tolerance for risk with an appropriate mix of stocks and bonds matching their long-term goals. Over time, the lump sum invested for growth could potentially yield better returns than the implied rate of return with pension payments.
Increased Control and Less Dependency on Company’s Future
By opting for a lump-sum benefit, a retiree becomes less dependent on their former employer to remain in operation and live up to its payment obligations. In today’s environment, every business is subject to increased risk, and while most plans are insured to some extent to pay pension obligations, it could give participants peace of mind to remove that potential altogether.
IRAs provide flexibility to control income streams compared to pension payments. Often, a retiree may need more money in some years and less in others. IRAs allow investors the option to tap the account as needed rather than getting the same payment monthly, needed or not.
Please keep in mind that rolling pension funds to an IRA does require more discipline and responsibility on the part of the retiree. Withdrawing funds at a sustainable rate and being patient during times of market uncertainty are key to successful outcomes. An account holder has to remember that these assets are intended to replicate a stream of income offered by traditional pension and avoiding multiple large withdrawals is imperative. Please consult a financial professional regarding your unique circumstances to determine if this strategy is appropriate for you.
Benefits Can Extend to Future Generations
Pension plan benefits will extend at most to one named survivor. In many plans that survivor is a spouse, and after their passing no further benefits would be paid to the employee’s family. By rolling pension funds to an IRA, children can be named contingent beneficiaries, ensuring any remaining benefit can continue to future generations.
Christopher N. Ruedi
Financial Advisor
CFP®, CFA®, RICP®, MBA