Pension Planning 101: How to Maximize Your Benefits in Retirement

Defined benefit plans—commonly referred to as pension plans—were once the lynchpin of a secure retirement in the United States. Today, pensions are few and far between. In fact, only 3% of private-sector workers have access to a defined benefit plan in 2021, according to the Bureau of Labor Statistics. Another 12% have access to both defined contribution and defined benefit plans. If you’re one of the lucky workers to still have a defined benefit plan, careful pension planning can help you maximize your payments in retirement.

The Importance of Pension Planning

Your pension plan may well be your primary source of income in retirement. If so, you have an important choice to make—specifically, which payout option is likely to maximize your benefits.

Like most financial decisions, there’s no one-size-fits-all solution. Your choice will be based on a variety of personal factors, including your family dynamics, age, health, lifestyle, and additional sources of income in retirement. Moreover, once you choose a payout option, your decision is irrevocable.

Put simply, if you’re vested in a defined benefit plan, pension planning is a critical component of your overall retirement plan. Ultimately, you want to create the most retirement income from your pension plan and its corresponding cash value.

Annuity vs. Lump Sum Payout: Which Payout Option Is Right for You?

Generally, employers offer their pension plan participants two options when they retire. First, you can take an annuity payout and receive a monthly check throughout your retirement. Your employer calculates the amount based on your age at retirement, your salary, and the number of years you’ve worked, among other variables. With this option, you know exactly how much income you’ll receive in retirement before you retire.

Alternatively, your employer may give you the option of taking a lump-sum distribution. With a lump-sum payout, you can roll the proceeds into an individual retirement account (IRA), which allows you to defer taxes until you make a withdrawal. You then become responsible for managing and investing the cash within your IRA and taking distributions as needed.

Pension Planning for an Annuity Payout

If you choose to take an annuity payout, you then must decide how you want to receive the annuity. Typically, you have three choices: single life, joint and survivor, or period certain. Keep in mind that federal law may limit your choices depending on your marital status and accrued benefits. Your employer may also offer different options than those listed below.

  • Single-Life Annuity. A single-life or straight-life annuity payment lasts your lifetime only. In other words, when you die, the payments stop—even if you die shortly after you retire. To hedge against this possibility, you can add a period-certain payout to the single-life option, so a beneficiary receives your pension payments for the remainder of the payout period. However, doing so will reduce your monthly benefit.
  • Joint-and-Survivor Annuity. A joint-and-survivor annuity payout lasts your lifetime, plus the lifetime of another person (typically your spouse). With this option, your monthly payment is less than it would be for a single-life annuity. However, if your spouse outlives you, they’ll receive at least 50% of your monthly benefit for the rest of their life.
  • Period-Certain Annuity. You can also add a period-certain payout to a joint-and-survivor annuity. In this case, you designate a payout period and a beneficiary. If both you and your spouse outlive the payout period, your beneficiary receives a monthly payment for the remainder. (In some cases, life insurance can be used to achieve the same goal. If you’re considering this option, be sure to consult with a financial advisor or insurance specialist.)

Annuity Payout Advantages & Disadvantages

One of the advantages of choosing an annuity payout is that you don’t have to worry about outliving your pension payments. And since you know your monthly pension income in advance, it’s easier to budget for that amount.

In addition, you may gain peace of mind knowing your heirs will benefit from your pension planning. Depending on your health, you may prefer an annuity payout, so they have a guaranteed source of income in your absence.

On the other hand, selecting an annuity payout introduces inflation risk. In other words, your monthly payments will potentially be worth less in the future if inflation is present. For context, the average annual inflation rate in the United States was 3.24%from 1914 to 2021, based on the Consumer Price Index.

Another risk is that your ongoing payments may be based on the financial health of your employer. If your employer files for bankruptcy, your pension benefits may be threatened. Although the Pension Benefit Guaranty Corporation (PBGC) provides a backstop when companies fail, it only protects your benefits up to certain limits.

Finally, an annuity payout may limit your ability to provide financially for future generations. Unlike other retirement accounts that can be transferred to your heirs, once annuity payments cease, there’s no account balance to pass along.

Pension Planning for a Lump-Sum Payout

If your employer offers a lump-sum payout, they will either issue a cash payment or transfer your balance to an IRA. The amount you receive is based on what the plan would have paid you as an annuity over your projected life expectancy, as well as the current interest rate. This rate is used to calculate what the plan would have earned on your cash balance if it had been paid out in installments over your lifetime. You’ll receive a smaller payout when interest rates are high and vice versa.

Lump-Sum Payout Advantages & Disadvantages

The primary advantage of a lump-sum payout is that you gain full control of your pension benefits when you retire. If you have a significantly younger spouse or want to provide for the next generation, a lump-sum payment may offer more flexibility than an annuity. In addition, you don’t have to worry about the ongoing financial health of your employer.

At the same time, you risk outliving your assets if you take a lump-sum payment. Poor investment decisions, market movement, and taxes can eat away at your account balance over time. Not to mention, if you don’t roll the balance over to an IRA, you may owe a significant tax bill at the time of payout. Working with a professional financial advisor can help you minimize or avoid these risks.

Pension Freezes & Buyouts

More recently, pension freezes and buyouts are becoming commonplace. High-profile examples include DuPont, General Electric, and IBM, among others.  As companies attempt to shed their pension liabilities, your pension planning may be affected as well.

When a company freezes its pension plan, participating employees may no longer accrue new benefits. However, they are entitled to the benefits they’ve accrued to that point. If your employer freezes your pension, be sure to request an updated retirement-benefit estimate. That way you can determine if you’ll need to supplement your retirement income with additional savings. You should also find out if your employer plans to offer new retirement benefits, such as a 401(k) match.

Alternatively, your employer may offer to buy you out of your future pension benefits. Generally, this means offering plan participants a lump-sum payment to absolve the company of its future pension obligations. If you receive a buyout offer, consider working with a financial advisor to run the numbers before committing to anything. Though a buyout may benefit your employer, it may not always be financially advantageous for you.

Planning for Multiple Pensions

If you’ve worked for multiple employers who have offered pension plans, it’s possible you may have more than one payout decision to consider. The good news is you don’t have to choose the same payout option for each plan. For example, you can take an annuity payout for one pension plan and a lump-sum payout for the others, if the option exists.

Again, proper pension planning is key. You may want to work with a financial advisor to help you maximize your benefits.

A Trusted Financial Advisor Can Help You with Pension Planning

Pensions are quickly becoming obsolete in the United States. If you’re one of the lucky few who has a pension plan, it’s important to weigh the pros and cons of each payout option before making a decision. Otherwise, you risk giving up benefits that you worked hard to earn.

There are many factors to consider during the pension planning process, including whether you’ll need additional sources of income in retirement. A trusted financial advisor can help you plan for various scenarios, so you can feel confident your future is secure.

If you need help maximizing your pension plan benefits and planning for a secure retirement, Milestone Asset Management Group can help. Our skilled team of experts works with you to run a detailed pension analysis, so you can make an informed decision based on your current and projected finances. Please schedule a call to get started. We look forward to hearing from you!