Higher interest rates are good for our cash and checking accounts but not always good for pensioners. The increase in interest rates has an inverse relationship with the lump-sum value of the pension. yip interest rates increased, the lump sum value of a pension container can be reduced. Because of this, I am looking at pension holders who want to take a lump sum to do so now vs. waiting.
I also see annuity rates increase with rising interest rates, pushing the annuity income to potentially be higher than the pension income (see chart below). There is a lot to consider if you have a pension now. Let’s review.
Pros and Cons of Taking Lump Sum
If you have a pension, you may be eligible for a lump sum – not all pensions have a lump-sum option. A lump sum is a one-time payment to replace a traditional single life or joint life pension income. The lump sum can be transferred to an IRA tax-free. Once in an IRA, the lump sum can be invested in mutual funds, stocks, CDs, annuities or many other investments (there are some limitations (opens in new tab)).
Here are four reasons pensioners transfer lump sums to an IRA, including drawbacks:
- More control. If you transfer a lump sum of pension to IRA, you control how the money is invested when taking distribution (or not). In effect, an IRA gives you more control over retirement assets. Of course, you can deplete the account faster if you end up spending too much, or the account can lose money if you invest in the stock market or bonds. On the other hand, if you fail to invest the lump-sum IRA properly, ie stay in low-yielding cash or CD, it may not grow as much as the pension.
- Money for children. A pension is the first and foremost retirement planning tool. Children are important, but they are not the only reason for how you make decisions. The good thing about transferring a lump sum to an IRA is that children can inherit the remaining account balance upon death if they become primary or secondary beneficiaries. It is not so if you choose pension income, the income stops at the second death if you choose a joint option, there is no remaining asset for the kids to inherit. , according to IRS rules (opens in new tab). Also, IRA withdrawals are taxable income, just like pension income (state tax laws vary).
- More growth potential. A pension is considered a conservative investment, usually earning low-single-digit returns. Low risk may suit your needs, but if you want more growth, you can transfer the lump sum to an IRA and invest accordingly. Of course, you can also lose money in an IRA, so you should know what you’re doing if you choose to invest with an IRA.
- You never know with a pension. Pension can be guaranteed by Pension Benefit Assurance Corporation (opens in new tab), but up to a certain amount. While the guarantee is comforting, I am skeptical. PBGC may change its rules and guarantees. Also, if you have a pension from a company that is in trouble, bought or sold or bankrupt, I am afraid that it will have to rework its pension offer.
Transferring a pension to an IRA may not make sense in that case pension payout ratio higher than your withdrawal rate. You also have to count speed you return on your pension and evaluate the tradeoffs. A qualified professional can also help you decide what is right for your overall retirement.
Compromise? Buy Annuity And Lump Sum
If you like the idea of a guaranteed income for retirement, but don’t want to inherit it from your children, now is the time to compare pension income and annuity income. Because interest rates have increased this year, I have seen annuity payout rates increase, and more and more annuities beat pension income.
Additionally, unlike traditional pension income, annuity balances can be left to children. Annuities come with many payout options, including a “cash back” option that pays the account balance to the beneficiary. The chart below is a real life example.
This client has a pension with a lump-sum option of $300,000 or a single lifetime income option that pays $19,996 a year. If the individual dies at the end of year 10, they accumulate $199,960 over their lifetime. The balance – $100,040 – was eliminated. Contrast this to a lump sum transfer to an immediate annuity with a cash refund. Not only does the annuity pay more annual income, but if the client dies within 10 years, children or other beneficiaries can inherit the remaining account balance of $100,040.
Children are not the main reason to choose a lump sum, but the annuity idea is like having your cake and eating it, too – retirement income for as long as you and your partner live (if you choose joint income), and the rest. Account balance can be given to kids.
There are different types types of annuities consider. An immediate income annuity pays current income. A deferred annuity to pay later. Personally, I tend to use a fixed deferred annuity, which is conservative, like most pensioners. It’s best to talk to an experienced independent advisor who can help you navigate your options.
What to watch out for with Annuities
No investment is perfect. Income annuity level for life, like a pension, and usually not adjusted for inflation. There may be an option for inflation-adjusted income, but then the overall income is usually less, especially in the first year.
There is creditor risk, too. Annuity investors rely on the solvency of the issuing company. For this reason, stick to highly rated carriers and consider carrier diversification – leave some pension lump sums in different companies.
Liquidity is another drawback; Some annuities have an early surrender penalty if you take out more than the scheduled income stream.
Finally, make sure you understand the costs. Some costs are variable, while some can be fixed.
“When the facts change, I change my mind,” said John Maynard Keynes, the great economist. Rising interest rates are changing the math for pension holders. If interest rates continue to rise, lump sums may not be worth as much as they are today. Now is a good time to evaluate your options.
Michael Aloi (opens in new tab) is a Certified Financial Planner with 22 years of experience. For more detailed information or a complimentary review of your pension options, please feel free to send him an email at [email protected]
Investment advisory and financial planning services offered through Summit Financial LLC, a SEC registered Investment advisor, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with an independent tax or legal advisor. An individual investor’s portfolio should be constructed according to the individual’s financial resources, investment objectives, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is no guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Summit is not responsible for hyperlinks and any external referenced information found in this article. 10282022-0778