If you're fortunate enough to be among the 29% of Americans with a company-funded pension,1 you probably have to make a one-time, irrevocable decision on in what form you want to receive your benefits.
Which option is best for you? It depends on your plan's options, your retirement needs, and your current financial situation. Here are three steps to help with that important decision.
Step 1: Understand your options
You may have a number of choices for your pension payment, but the three common options are: a series of regular periodic payments for life (a life annuity), a lump sum, or a combination of the two. Check with your benefits department for your options.
Regular periodic payments
By law, a pension plan must provide a life annuity option (see table below). A typical life annuity pays the same amount every month for the rest of your life or for at least for a specified period of time, often with payments continuing for the life of your beneficiary (typically your spouse). The appeal? It provides a steady stream of income during retirement, and helps ensure that you (and potentially your spouse) don't prematurely run out of money.
But you need to know that:
- These annuities typically aren't adjusted for inflation, so you may lose purchasing power over time.
- If you "annuitize" your entire benefit, you won't have access to a lump sum to pay for unexpected bills or large purchases.
- Although the government's Pension Benefit Guaranty Corporation (PBGC) insures many private sector defined benefit plans up to certain limits, collecting your pension may be dependent on your employer's ability to pay.2
Taking a lump sum
Your pension plan may offer a one-time lump-sum payment in lieu of or in addition to a life annuity. The payment options available to a participant are governed by the plan. The lump sum is typically determined using interest rate and life expectancy assumptions, and equals the total of your expected lifetime annuity payments, discounted to today's dollars.
Taking a lump-sum payment can give you more flexibility with your money. You decide how to invest it and can use it when and how you want. Also, when you pass away, you may have some of it left for your heirs. But, unlike an annuity, it will be up to you to ensure that your lump sum will last in retirement. This likely means investing some of it in the stock market to potentially generate capital appreciation. So you would need to be comfortable with volatility and changes in the value of your investments.
When you take your lump-sum distribution, you should consider rolling it directly into an IRA to avoid a taxable event.
You could also use some or all of the lump sum to purchase a guaranteed lifetime income annuity from an insurance company. This may provide options that your employer's plan doesn't, such as inflation protection or a cash refund, or it may pay out more monthly income. That said, it is critical to choose a highly rated carrier to help minimize the possibility of default.
Combination of regular payments and lump sum
If your plan allows it, you could take part of your benefit as an annuity and the rest as a lump sum. Your monthly payment and lump sum would be smaller than if you selected only one payment form, but, in total, both are intended to be approximately equivalent to the normal life annuity under the plan. A combination option could give you the accessibility and liquidity of a lump sum plus the "guaranteed" stream of income from the life annuity.
Step 2: Determine which option is right for you
Seeing how various retirement and benefit start dates would affect your benefits can help with your decision. You may find it makes sense to work a little longer to accrue more benefits, or begin your benefit early if your plan offers an early retirement package. Your employer may have an online tool that evaluates different scenarios. If not, get all the information you can about your plan and then request pension estimates for each of the options. To compare options, use the relative values from the estimates.
One of our key tenets for retirement planning is that retirees should ensure that their essential expenses, like food, clothing, health care, and a place to live, are covered by "guaranteed" income from sources like pensions, annuities, and Social Security. Then you can use savings and other less predictable income, such as part-time employment, to cover things that aren't "essential" but are nice to do in retirement, like traveling and dining out. Also, you may be able to invest some of your savings in the stock market for growth. Because nonessential expenses are just that, you can vary those expenses during different market periods. In good times you can travel more; in tougher times, perhaps less.
Consider your essential expenses first when determining which type of distribution to take. For instance, if you have enough "guaranteed" income from other sources, a lump sum may be most appropriate. On the other hand, while you don't want cash-flow shortfalls in retirement, you don't want to lock up too much money in inflexible investment options, which may limit your long-term growth and tie up more of your money than necessary.
Here are some hypothetical examples that may help you when making a decision.
Concerned about outliving savings?
Mike is 65 years old, single, and in good health. Many family members have lived long lives. He chose his employer plan's single-life annuity option because he isn't concerned about leaving money to heirs. His concern: outliving his savings. After shopping around, he knew his employer provided a competitively priced annuity. Plus, he has other investments that can help ensure his income keeps up with inflation over his retirement.
Sam and Elaine are both 65. Sam is about to retire. Elaine never worked outside the home. They are both in relatively good health and are looking forward to traveling and volunteering. They want to ensure that they won't run out of money in retirement. After shopping around, they found a highly rated insurer that offered better rates for a joint and survivor annuity than Sam's plan did. He chose the lump-sum distribution, had it directly rolled over into an IRA to maintain tax deferral, and then withdrew from the IRA to buy the annuity. Note: The tax consequences of an annuity purchase with qualified assets should be considered carefully.
Essentials covered, growth wanted
Audrey, a 65-year-old widow with two adult children, is about to retire. She has a sizable investment account, but lives modestly and expects to cover most of her expenses with Social Security and an existing joint and survivor annuity from her deceased husband. She wants to pass on as much as she can to her heirs. She takes a lump-sum distribution from her employer, rolls it into her IRA, and invests that money for growth.
Step 3: Implement wisely
One of the best ways to help make informed decisions about retirement is to have an income plan. It can help you see if your essential and discretionary expenses will be covered throughout retirement, which in turn can help you make an informed decision about your pension distribution. (If you don't already have an income plan use the Fidelity Income Strategy EvaluatorSM 3 to develop and explore income strategies.)
Once you make your decision, there are still choices and next steps.
When choosing an annuity:
- Annuitize what you need for essential expenses. If you don't need your full pension amount for income, consider an annuity that covers your essential expenses and then take the remainder as a lump sum.
- Choose the right payment (if your plan provides options). If you're married and you both are healthy, we generally recommend a joint and survivor annuity (either a 50% or 66-2/3% option, depending on availability). Also, consider either a 10-year guaranteed period or cash refund. You may also select an annual increase option, such as 2% or 3% per year, to help your income keep pace with inflation.
- Choose the right annuity and provider. The cost of the annuity you purchase on your own will depend on many factors, including age, the type of annuity you select (single life or joint and survivor), and interest rates at the time. Again, we believe you should consider highly rated carriers.
- Get the best annuity rate possible. While a company plan typically pays a competitive rate, it's best to confirm this by shopping around. If you find a better rate, you may want to take your pension as a lump sum, directly roll it over to an IRA, and then use some or all of it to purchase an immediate annuity. As the name suggests, an immediate annuity, unlike a deferred annuity, begins payments right away.
- Consider diversifying annuities. When purchasing an annuity on your own, you may want to purchase several over several years to help smooth out potential fluctuations in interest rates. You can also purchase annuities from several insurers instead of just one, to help further minimize the risk of insurer insolvency.
- Consider when you will need income. If you do not need income right away but will in the future, consider a deferred income annuity (DIA) that will provide guaranteed income at a later date in the future. The income from a DIA may be higher due to the deferral period.
When taking a lump-sum distribution:
- Consider rolling over your distribution to an IRA to avoid a taxable event. A direct rollover, from your employer to your IRA provider (trustee-to-trustee), is the best way to preserve the tax-deferred status of your pension money.
- Invest wisely for retirement with an appropriate mix of investments in your IRA.
- Manage withdrawals by determining how much you can safely withdraw throughout retirement.
- Consider working with a Fidelity investment professional one on one to review or develop your retirement income plan based on your individual situation.
- Consider investment options that can help generate an income stream in retirement, such annuities.
- See whether your plan is on track with Retirement Quick Check and Retirement Income Planner (log in required).
Before investing, consider the investment objectives, risks, charges, and expenses of the annuity and its investment options. Call or write to Fidelity or visit Fidelity.com for a free prospectus and, if available, a summary prospectus containing this information. Read it carefully.
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