In the not-too-distant past, workers with a traditional employer-sponsored defined benefit retirement plan — or pension — had only two choices when it came time to retire — a lump-sum distribution or a monthly pension/annuity.
In September, however, the Internal Revenue Service (IRS) and the Treasury Department paved the way for employers to offer a third option to retiring workers that doesn’t force them to pick one or the other of the traditional options.
In the future, employers — or at least those who adopt the new rules — can offer workers the chance to take distributions partially as a monthly pension/annuity and partially as a lump-sum payment. And that kind of flexibility can be a good thing, especially since many workers were seemingly not choosing the best option in the past.
“The IRS released these regulations because it found that the current rules encouraged individuals to choose a lump-sum option, rather than the lifetime annuity option that would protect against the risk of outliving retirement savings,” Robert Bloink, a law professor at Texas A&M University School of Law, and William Byrnes, an executive law professor and associate dean for special projects at Texas A&M University School of Law, wrote recently in a trade publication.
Of course, deciding which option — lump sum, monthly pension/annuity, or partial lump sum and partial annuity — is best for you will require some number crunching and soul searching. How best to go about it? Consider the following:
Your household’s need for guaranteed lifetime income
Many experts suggest using guaranteed sources of lifetime income, such as Social Security and annuities, to fund your essential living expenses in retirement, and using other assets to fund your discretionary expenses.
So, to determine how much of your employer-sponsored retirement plan to take as an annuity and how much to take as a lump sum, first calculate your essential retirement expenses — housing, health care, food and the like — and then calculate how much guaranteed lifetime income you’ll receive from Social Security and other lifetime sources.
If there’s a gap, consider taking a monthly pension in an amount that makes up the difference between your essential expenses and guaranteed sources of income. For instance, if you have $ 4,000 a month in essential expenses and $ 3,000 a month in guaranteed income, consider taking a partial annuity of $ 1,000 a month, and the rest as a lump sum. If, however, your guaranteed income is greater than your essential expenses, consider taking a smaller or no monthly pension.
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Consider too how much money you might need in reserve for emergencies. If you take only a pension, it might be difficult to fund unexpected expenses. “For many people, taking a partial lump sum and a partial annuity distribution will be a very good choice,” said Anna Rappaport, president at Anna Rappaport Consulting. “Society of Actuaries research shows that many people do not consider irregular and unpredictable expenses in planning. Even expenses like home repairs and dental that are expected, but the timing and amounts are uncertain, are often not planned for.”
Rappaport also noted that Society of Actuaries research shows that many people are focusing on the short-term rather than the long-term. “Changes in income requirements are likely in the long-term,” she said. “Some people will choose more income in steps, rather than all at once. Making the choice between how much lump sum and how much annuity is a balancing act.”
Rappaport also said it’s important to remember that couples need to plan for the period until the last one dies. The Society of Actuaries longevity calculator offers insights into that period. Read also: Lump Sum or Monthly Pension: Which to Take?
Your money management skills
In the past, if you wanted the responsibility for managing your money, you likely took the lump-sum payment. But if you were unsure of your money management skills, you likely left the money with your employer and took the pension. There was no middle ground. Now, however, you can decide how much responsibility you’re willing to take, you can strike a happy medium.
“Ultimately, the choice between taking a lump sum or annuity — or combination of the two — should center upon the individual’s desire and ability to control the pension funds,” said Bloink. “The key question to ask is how the worker will reinvest a lump sum and manage the funds in the future.”
So, if, for instance, the worker doesn’t feel comfortable with his or her ability to successfully and responsibly manage the lump sum, either alone or with the help of a competent financial adviser, Bloink said the pension-managed annuity may be the appropriate choice.
Bloink also said the new regulations allow a worker who may be uncomfortable with managing the funds independently, but is also skeptical of the pension’s stability, to hedge his or her bets by leaving only a portion of the entire benefit within the pension.
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Your tax situation
Creating the most tax-efficient stream of income ought to be among your top goals in retirement. And to that, you need to run some what-if scenarios that estimate what your tax bills will look like over time should you take a lump sum, the monthly pension, or a mix of lump sum and pension. Income tax professionals, such as CPAs, should be able to run the numbers for you with their tax software programs. As you go through this process, you’ll learn which options provide you with the most after-tax income. “Rolling the funds into an IRA can help the individual avoid current taxation on the lump sum,” said Bloink.
Your — and your pension’s — health
Your life expectancy and the perceived health of the pension can also be factors to consider. “If the individual or the pension is unhealthy, this should cause the worker to lean toward the lump sum (or combination lump sum-annuity) option,” Bloink said. “If the worker is relatively young and healthy, he or she should consider the security that an annuity stream can offer for life.”
When considering the value of the pension-managed annuity, Bloink also said the worker should compare the cost of purchasing a commercial annuity with the lump-sum amount if he or she is uncomfortable with the pension’s stability. “The inflation protection and indexing options that are typically available in a commercial annuity, but not in a pension-managed annuity, should also be considered,” he said.
The case for a partial or full lump sum payout
Jason Scott, managing director of the Retiree Research Center at Financial Engines, said his firm’s research shows that a common strategy people use — taking Social Security and a corporate pension right at retirement — is usually a demonstrably inferior strategy.
“A better strategy would be to cash out some or all of the corporate pension and use the proceeds to defer Social Security,” he said. “This is true for many people, and definitely the case for a married person who is the high wage earner in the household.”
He offered a strategy that workers faced with deciding lump sum, pension, or partial lump sum and partial annuity could use:
Step 1: Use a Social Security planner to get a claiming strategy that maximizes lifetime Social Security payments. (Financial Engines has a planner on its website, but there are others one could use as well.)
Step 2: The recommended strategy often suggests deferring Social Security. “If funding the deferral is not financially feasible, consider working longer or consider taking a partial lump sum cash out from your pension to fund the deferral,” Scott said.
Scott noted that being able to take a partial cash out is significant because it makes step 2 much more feasible. “Often with this approach you can create higher total monthly payments as well as have cash left over from the lump-sum distribution,” he said. “Not too bad.”
Robert Powell is editor of Retirement Weekly, published by MarketWatch. Get a 30-day free trial to Retirement Weekly. Follow Bob’s tweets at RJPIII. Got questions about retirement? Get answers. Send Bob an email here.