Lump-sum or annuitize? Life-only annuity or joint and survivor annuity benefit? Pension maximization requires careful consideration of these questions and many other factors.
Pension Maximization and the Key Considerations to Solve the Pension Quandary
I spent nine years working for Rockwell Automation. I would consider myself fortunate to be among a declining population of automation industry workers who will retire with the benefit of a pension. There is regular interaction with professionals from the manufacturing and technology space. They are faced with the question of what to do with their pension benefits as they approach retirement. This decision has large implications and should not be taken lightly.
What Are the Options?
Most plans, like Rockwell Automation’s, will offer a lump sum payout or the option of annuitizing your benefit. While the payout option is fairly straightforward (more on this later) your pension plan likely offers a number of annuity options to choose from.
These options usually include a single-life (life only) annuity and several joint and survivor annuities which provide a surviving spouse a certain share of the retiree’s original monthly benefit for the rest of their life. The survivor benefit is often 50%, 75% or 100% of the retiree’s single-life annuity amount. The monthly annuity payout is highest for the single-life option and decreases as the joint and survivor benefit percentage increases. The declining payout (relative to the life-annuity option) reflects the risk of the plan-making payments over a longer period compared to a single life pension.
Should the lump-sum payout option be selected, the tax-deferred benefit of the proceeds will likely be preserved. The preservation would occur by rolling the funds over into an IRA. Here the funds will hopefully be invested in a balanced and diversified manner with the goal of producing a better monthly income than would be provided by otherwise annuitizing your pension benefit.
Those, in essence, are your options. Now the tough part: deciding which choice maximizes your benefit.
No two retirees, or retirements, are the same and never will be. We each have unique goals, needs, and means when it comes to retirement. These factors will influence the value we place on the different pension benefit options offered. Consider the following scenarios:
- An early retiree (say, age 60) needing to consider a longer retirement period and the added risks that come with it (ie – market volatility, longevity).
- A soon-to-be retiree who wants to emphasize their legacy by passing along wealth to family or a charity.
- A retiree with a younger spouse who will likely have retirement income needs long after their passing.
- A couple with a ‘fully funded’ retirement and diversity in guaranteed income sources (ie – Social Security, annuities, supplemental income from a rental property, etc).
In each of these cases, the value a retiree receives will vary from option to option, often significantly. That early retiree, with a longer retirement, may find greater value in the life-long guaranteed income of an annuitized pension. A couple that has already built a large, and diverse, retirement income floor will likely get more benefit from the lump sum payout.
We all want to get the most out of our pension. What that entails and the option that we select depends on our unique situation. However, there are a couple of valuable approaches worth considering as you make this decision.
The ‘Pension Maximization’ strategy is one of these options. This approach uses life insurance to maximize your pension annuity amount. Instead of taking a lower monthly payment that would include a spousal benefit, you would select the highest annuity payout amount: the single-life annuity. Keep in mind though the risk that comes with this selection; In the event of your untimely passing, your spouse remains without this potentially important income source. This could leave your significant other in an untenable position!
This risk can be mitigated by using a portion (or all) of the payout difference between your single-life and joint-and-survivor annuities, to purchase a life insurance policy. This policy’s death benefit would kick in to help fund your spouse’s retirement should you pass away. In theory, this would be a win-win: you get the maximum annuity payout from your pension while maintaining a security blanket for your surviving spouse.
Like most anything; however, there are several important additional pros and cons to be aware of as you consider this option:
- The life insurance payout your spouse would receive is 100% tax free thus reducing the amount of life insurance you would otherwise need to purchase to replace your pension annuity.
- If your spousal beneficiary passes away, you still receive your ‘maximized’ pension payment. You could cancel the life insurance policy and associated premium (or use it to provide for another family member).
- Pension maximization is a flexible strategy in that it is not an either-or option. A retiree could protect a 50% spousal benefit through their pension and use life insurance (with a lower benefit and premium) to cover the rest.
- The cost of life insurance increases with age and can be expensive to purchase the closer you get to retirement. This increased cost can quickly ‘eat away’ at the difference between your higher single-life annuity and the joint-and-survivor option.
- You may not be insurable due to health conditions or family health history.
This quandary of taking a lump sum payout versus annuitizing your benefit versus the pension maximization approach begs to question: how does one also objectively measure the value of each option in picking the best solution?
Probability Adjusted Net Present Value Analysis
Enter the ‘probability adjusted, net present value analysis. While that sounds very scientific and potentially overwhelming, the concept is both fairly straightforward and important. Calculating and comparing the present values of your lump sum payout relative to your annuity payment options is not enough. It is not a fair or accurate comparison.
Why is that? The probability of you living another year decreases with each passing birthday. Though this decrease may be small from year to year, it adds up over the longer term. If you choose to annuitize your pension benefit, the present value of those future payments should adjust (down) by the probability of you still being alive, should they not? Far too often, this probability factor is ignored when evaluating options using the present value comparison. This can lead to flawed decision making and who wants to run the risk of that when it comes to something as important as your pension?
Using the Social Security Administration’s (SSA) actuarial life table we in the financial advisory community have developed a tool for properly calculating present value. It aids in comparing the probability-adjusted present value of all your pension benefit options, including the pension maximization approach. When used in a decision-making framework that factors in all other considerations (ie – retirement life expectancy, health, legacy goals, retirement income floor, etc), this tool helps to ensure that you’ve made a decision that maximizes your benefit.
And who doesn’t want that reassurance? Feel free to reach out and discuss pension maximization and framework further. We are committed to helping you make the best decision given your unique situation!