Making the Decision: Which Pension Payout Option is Best?

August 30, 2011

I recently met with a multitude of pre-retirees for individual consultations who were contemplating an early retirement deal, so naturally part of the analysis revolved around their pension.  I was stunned at the amount of employees who, up until our in person meeting, had never gone online to run a pension estimate.  Of those who had already run their estimate, quite a few were still unclear about the various payout options and how to go about making the decision on which payout best fit their own situation.  The most common question I got was, “What do most employees pick?”  Although I was very tempted to bring up the old adage mom used to say that, “if everyone else jumped off a bridge, would you do that, too?”  I resisted, and instead, I stressed to them that it was a personal decision based on their own unique situation.  Here are the points I had the employees consider:

  • Do you have a loved one who you would  want to benefit from the pension if they outlived you?
  • Who is this beneficiary (spouse, child, parent, significant other, etc), and what is their age?
  • How is the health of both the beneficiary and employee, and does longevity run in their family or yours?
  • If you took a lump sum, do you feel comfortable with making investment and withdrawal decisions that can withstand market risk and the possibility of running out of money too soon?

After gaining insight into who the beneficiary would be, we then took a look at what each of the payout options were, and what the pros and cons were for both the employee and the beneficiary.  Listed below are the typical payout options offered by a defined benefit or cash balance plan and a brief explanation of each:

  • Lump sum payout – 1 time distribution of the current value of the pension, with no future benefit available for either the retiree or beneficiary.  This lump sum would be considered a taxable distribution unless the amount was rolled into a 401(k), 403(b), or Traditional IRA.
  • Life only annuity – monthly payments that continue for a lifetime for the retiree only (no payments to a beneficiary), and are considered as ordinary income for tax purposes.
  • 50% Survivor annuity – monthly payments that are reduced in half upon the death of the retiree and which are then paid out to the beneficiary for their lifetime, if the beneficiary outlives the employee.  There is usually a reduction in the monthly payout, compared to the life only the retiree receives, that is determined by the age of the beneficiary.  The younger the beneficiary, the larger the reduction.
  • 100% Survivor annuity – monthly payments that continue in full until the death of both the retiree and the beneficiary.  Again, there is a reduced monthly benefit compared to both the life only and the 50% survivor payouts based on the age of the beneficiary.
  • 10 Year Certain life annuity – monthly payments for the lifetime of the retiree, but if the retiree dies prior to 10 years, then the remainder of the monthly payments for the 10 years will be paid to the beneficiary.  There are sometimes other variations of this, such as a 5 year, 15 year, or even a 20 year timeframe to choose from.

The most common misconceptions that I hear regarding these options, are about the Survivor annuity being only available for a spouse, the lump sum always being taxed  immediately upon receipt, and the biggest confusion is with the 10 Year Certain thinking that the pension stops at the 10 year mark for the retiree.  Employees have the Summary Plan Description (SPD) available, but sometimes these SPDs are written in legal jargon and can be very hard to understand.  According to a recent Fidelity study, 71% of plan participants surveyed stated they did not have detailed knowledge about how their pension plan operated, and 40% didn’t even know what payment options were available.

Making a personalized consultation available for pre-retirees can be very beneficial to help clarify what these payout options mean and what the costs and consequences are of each option.  Another idea is to put together a “People Like Me” brochure that gives case studies of different retiree scenarios, and which payout option fits that employee best.  This can also alleviate the curiosity factor of “what do most employees pick.”