If you're eligible for a defined benefit retirement plan, or pension plan, your company may soon be calling on you to take a lump-sum buyout, if they haven't already.
The reasons for this reflect a larger trend of companies shifting from offering defined benefit (DB) plans to defined contribution plans such as 401(k)s. In doing so, companies have also increasingly been trying to remove already-existing DB liabilities from their balance sheets, often by offering lump-sum payouts to eligible participants or transferring the plans to a third party, usually an insurance company. Recently, rising interest rates—along with the combination of equity performance over the past several years—have resulted in pension obligations being well- or overfunded, which makes them easier to offload.
Rising interest rates can also decrease the amount of lump-sum payouts that are offered to eligible workers. That's because the amount of those payouts is generally determined by a bunch of actuarial factors including your age and life expectancy, as well as the present value of your future guaranteed income. That present value calculation incorporates a set of interest rates, known as Minimum Present Value Segment Rates or Segment Rates, that is updated monthly by the IRS. All else being equal, the higher interest rates are, the lower the lump-sum amount you may be offered.
While the pace of Federal interest rate hikes may be slowing, it's possible they will continue to rise this year, which means a lump-sum offer in the future may be meaningfully lower than one offered today. Regardless, determining whether to take a lump sum versus a guaranteed monthly retirement benefit could be one of the most important financial decisions of your life.
Since every participant's situation is unique, these determinations should be made as part of a comprehensive financial planning exercise, and it's extremely important to discuss pension decisions with your financial professional and tax professional. Below are some of the considerations to keep in mind.
The specifics of your company's plan. Typically, employees eligible for DB plans who opt for an annuity can elect from several options, which may include a benefit that terminates at the employees' death or one that continues some or all of the benefit for a beneficiary or spouse for a certain period or lifetime.
A single life option typically has the largest monthly benefit, but also carries the risk of premature death. In that situation, the employee's surviving family would typically receive no further benefits. (For more detail on monthly payments, see Lump-sum payment or monthly pension?)
Income needs in retirement. To what extent, if any, are you counting on the DB income to sustain your lifestyle and pay for medical expenses and other necessities during retirement? If you opt for a lump sum, you bear the burden of investing, protecting, and managing the assets to ensure they can generate enough income throughout your and (potentially) your spouse's retirement. However, unless your company's plan offers an inflation protection option, the purchasing power of an annuity payout would be eroded by inflation.
If you have other reliable sources of retirement funds, you may consider electing a lump-sum payout and investing the funds, perhaps by rolling the lump sum into a traditional IRA (which could subsequently be converted into a Roth IRA) or paying appropriate income taxes and adding to a brokerage account. In some cases, using the lump sum to purchase an annuity within an IRA may result in a larger monthly payment (or a lower amount could be used to match what was offered from the company, allowing you to invest the difference) as well as additional investment options. But it's important to keep in mind that an annuity inside an IRA offers no additional tax deferral benefits, and there are numerous other considerations, including the strength of your employer's balance sheet compared to the insurance company, your wealth transfer plans, and your family's financial needs and goals.
Assumed life expectancy. If you know from your own or your family's health history that you are at greater risk of a premature death, then the lump-sum option or a joint and survivor annuity (if available) may be a better choice than a single life annuity that only pays out over your lifetime.
Investment expertise. In most cases, a lump-sum payout will require that you have the wherewithal to research and select investments, and continuously monitor and rebalance the portfolio. Moreover, in non-tax-advantaged accounts, tax-efficient investing becomes an important consideration. Emotion and lack of discipline, coupled with lack of expertise, could result in underperforming investments, which could significantly impact the financial resources available during your retirement.
Wealth transfer goals. In many cases, choosing a lump sum provides the most flexibility from a wealth transfer perspective, since it can allow you to control how the assets will pass upon your death. You can potentially even name a trust as the beneficiary and further control the distribution of assets for multiple generations. By contrast, in a single life or joint and survivor pension annuity, in most cases, there is no option to name a beneficiary to receive those assets when the original owner passes.
Deciding between an annuity and a lump-sum payout is complex. Your attorney or financial professional can help you think through the considerations in light of your family's overall financial and wealth transfer goals.