Selecting a Company Pension Payment Plan
Managing Your Retirement
Retirement. A time to get out on the golf course more often, travel, spend additional time with your family, pamper your grandchildren, generally reflect upon how hard you've worked (and how kids these days don't know how easy they've got it), and, if one were to believe certain television commercials, take up rollerblading and skydiving to prove that you're "getting more out of life."
Your ability to fully indulge yourself in whichever of these activities actually appeals to you (if any) will depend to a great extent on how well you arrange the finances that you'll have for your retirement, and for many Fools, that starts with looking at your company pension -- or in more highfalutin language, a "defined benefit plan."
A defined benefit plan provides a specific and guaranteed retirement income, typically based on the number of years of employment, an average of the final few years of salary (as the final years will in most cases be the highest annual salaries of an employee's career), and a percentage multiplier. (For details, see the discussion in our Foolish Retirement Plan Primer.) This benefit is normally paid out as a monthly pension for life with an additional percentage payable to a surviving spouse following the death of the pensioner.
Below are some typical annuity options from which a pensioner may choose. An annuity is nothing more than a payment made over time, and that time may be for life or for a specified period of years. Also, bear in mind that only one option may be elected, and once it's chosen, that election can't be altered, changed, folded, spindled, or mutilated for any reason. Finally, some definitions may be in order:
- "Joint and 50%" means you will collect a payment for life. On your death, your spouse will receive half of that amount for the remainder of his/her life.
- "Joint and 66 2/3%" means you will collect a payment for life. On your death, your spouse will receive two-thirds of that amount for the remainder of his/her life.
- "Joint and 100%" means you will collect a payment for life. On your death, your spouse will receive the same amount for the remainder of his/her life.
- "10-Year Certain & Life" means you will collect a payment for life. If you die within 10 years of retirement, your designated beneficiary will collect the same amount until reaching the 10th anniversary of your retirement. At that time, all payments cease. If you die after you have been retired for 10 years or more, all payments cease on the day of your death.
- "Life Only" means that you will collect a payment for your life. At your death, all payments cease.
- "Lump sum" means you take the present cash value of the future stream of payments of the basic annuity benefit prescribed by the plan (usually a Joint & 50% annuity). On payment of the lump sum, all benefits have been disbursed by the plan to you, and no further benefits are due.
The dollar amounts in the chart below are just hypothetical, given to demonstrate the different percentages available for each choice.
|Form of Annuity||Your Monthly Benefit||Surviving Spouse's
|Joint and 50%||$1,225.68||$612.84|
|Joint and 66 2/3%||1,176.65||784.43|
|Joint and 100%||1,066.34||1,066.34|
|10-Year Certain & Life||1,176.20|
|Lump Sum Payment||$210,082.79|
These choices may look enormously different to you -- but as far as your company is concerned, they'll all end up costing about the same. That is, the company has had actuaries look at thousands upon millions of life expectancy tables, tally up how many people at the company are likely to be smokers, teetotalers, hang-gliders, or couch potatoes, and figure out about how long its employees and their spouses are likely to live.
No matter which option is chosen, the company figures its expected cost should average out to be exactly the same. Of course, you're an individual and not a composite average of thousands of individuals. (Hopefully. You can tell if you're a composite by counting your children. If you have 2.7 of them, you're a composite. Call Ripley's Believe it or Not, or write us a Fribble about the experience.) For individuals, the options can provide very different payouts over the course of a lifetime.
You may choose any of the three joint annuities without having your spouse sign off on the choice. But if you elect the 10-year certain annuity, the life-only annuity, or the lump-sum payment, then you must obtain your spouse's permission to do so. Ain't that a kick in the pants? You do the work, but your spouse says how you'll take the reward. By law, your spouse must sign a statement acknowledging that he or she would not be entitled to any further benefit at the time of your death, and have that signature notarized.
Without that notarized statement, the plan may only pay one of the three joint annuity benefits. (So, if you're trying to slip one by your spouse by whispering sweet nothings in his ear and having him sign the lump-sum payment option while he's distracted, just realize you'll have to pull the same trick with a notary as well.) Notice that in the three joint annuities, as the benefit to the surviving spouse increases, the benefit payable during your life decreases.
With any of the annuities, your annual income is known, and that income will continue for your lifetime and possibly your spouse's as well. With a lump-sum payment, your annual income will depend on how you invest that sum and on how much you withdraw each year. It may or may not last for the rest of your and your spouse's lives, but invested Foolishly it can provide inflation protection for your income.
One drawback to the annuity payments is that they may not be transferred to an Individual Retirement Account (IRA), and must be declared as income and taxed as such in the year received. In most plans, the annuity and the surviving spouse benefit will not increase during retirement. They will be the same 20 years from now as they are today. If inflation averages 4% per year in that period, that means the annuities will then be worth about 45.6% of what they are today in terms of purchasing power. (Now you see why it's good that Federal Reserve Chairman Greenspan is always on the lookout for inflation.) By taking an annuity you gain the security of guaranteed income, but because of inflation you also gain the guarantee of a gradual reduction in your purchasing power.
While it does not provide the same security of guaranteed income every year, a lump-sum payment does provide a few advantages and additional options that annuities do not. You may take the money from a lump-sum payment and deposit it in your bank. You may transfer it to an IRA. (A traditional IRA, that is. You may not transfer a lump-sum payment to a Roth IRA.) Or you may take part and transfer the rest to an IRA. Any money you do not transfer to an IRA is taxed as ordinary income as you receive it. Any money transferred to an IRA will not be taxed until withdrawn from that IRA.
The Most Foolish Choice?
Arguably, a lump-sum payment is the most Foolish of the payout options available. A Fool who is comfortable with handling her own investments can take the lump sum and likely do better on her own than with an annuity. Taking the numbers above, it would only require seeing about a 7.6% annual return on the $210,082.79 to get a better annual payout than the annuity options available. Investing in an equal mix of bonds and stocks will, over most 15- or 20-year time periods, provide returns that would beat 7%.
If you do take the lump-sum payment, in most cases it's usually best on the pocketbook to keep only what's currently needed for income and transfer the remaining monies directly to an IRA. That lessens the current year's tax bite. But we don't want to oversimplify here. You must look at your entire financial situation to evaluate the tax impact of keeping the money and paying taxes today versus deferring those taxes to future years through withdrawals from an IRA. (This is a topic that requires discussion with your tax advisor, who is in the best position to analyze the alternatives. That analysis may cost you a few hundred dollars, but it could also save you far more in income and/or estate taxes as well. Consider the fees paid to the tax advisor money well spent because he may very well save you from a costly error.)
Company pension plan distribution options may confuse you at first. But if you take the time to learn what your plan allows and ask questions of your plan administrator or post questions on our Retirement Investing message board, you should soon have all the information you need to make a fully informed decision.
That's it for the company pension plan. Onward we go to the 401(k), or Defined Contribution Plan. Isn't this fun?