Most employers have transitioned over to 401(k) plans, but many people in their 50s and 60s still have the older defined-benefit pension plans. And they’re understandably confused when it comes time at retirement to decide which option to select. Unfortunately, I’ve seen some inaccurate, unhelpful, and even misleading information from respectable sources on this topic. If the alleged experts are confused, one can easily imagine that pension participants are confused, too.
There are a couple of key concepts to consider up front. First, are you married? If so, then you have to think about the financial security of your spouse if you die early in retirement. Second, do you have a lump sum option or must you receive your pension benefits in the form of monthly payments?
In general, pension participants can receive benefits in one of two ways: either a monthly payment or a lump-sum option. If a monthly payment is elected – and if you are married – then you and your spouse must decide whether to elect a joint-and-survivor option, but this means that your pension payments will be reduced.
Various options are offered to protect a spouse in case you die first. For example, if a $3,000/month payment is offered for your life (“Life-Only Option”), you might also have the option of reducing this amount to $2,700/month, but your spouse would continue to receive 50% of your pension – or $1,350/month ($2,700 x .5). This is called a joint-and-survivor option (“J&S Option”). In my experience, most people elect the J&S Option. But oftentimes purchasing an individual life insurance policy and electing the Life-Only Option from your pension plan may be a better choice. The lump-sum option might even make sense.
Whether a Life-Only option or taking a lump sum is a better choice will depend heavily on a family’s financial situation, health of the parties involved, and their financial goals. It’s important to get this decision right, because there generally are no “do-overs” once you start receiving monthly pension payments.
Lump Sum or Monthly Payments?
The first decision that must be made is whether to elect a lump-sum payment or monthly payments. More plans are offering lump-sum payments to reduce liabilities on balance sheets. Every situation is unique and must be considered with great care. Consider:
Monthly Payments – Life-Only or J&S Option
If you decide that monthly payments are best – and you are married – now it’s time to consider which monthly payment option to select. Protecting your spouse with a J&S Option is called a joint-and-survivor benefit, but in my opinion, it might as well be called the “cheap, low-quality life insurance option.” This option will protect your spouse, but there might be better ways to do it.
In general, there are four basic ways your life expectancy in retirement will play out:
1) You both live your normal life expectancy – the most likely scenario, if you’re healthy.
2) You both die early in retirement – unlikely, but something to consider.
3) Only your spouse dies early in retirement (does your plan have a “pop-up” provision?)
4) Only you die early in retirement – hence the need for spousal protection.
Let’s examine each scenario.
You Both Live Your Normal Life Expectancy
Assuming you are both healthy, the most likely scenario is that you and your spouse live your normal life expectancy. Even if you elect a J&S Option, your pension plan will only pay income if either of you are alive. But this income stops when you both pass away. Fair enough. But what if it’s important to you to leave some money to the kids, grandchildren, or a charity? Then your pension will not help you with this goal. You could fund this goal with other assets, but a life insurance policy – properly structured and funded – would pay a death benefit and satisfy this goal. In this case, we might take the extra pension benefits received from a Life-Only Option (instead of a J&S Option) and use those benefits to purchase life insurance.
You Both Pass Away Early in Retirement
The analysis here is similar to the analysis immediately above. You both die, the pension payments stop. Again, your family or a charity generally receive nothing from the pension plan.
Your Spouse Dies Early in Retirement
Many plans contain a “pop-up” provision, but many don’t. A pop-up provision allows the pension participant to “pop up” to the original Life-Only amount in case the spouse of the participant dies early in retirement. To use our example above, if you elected a 50% JS Option at $2,700/month instead of $3,000/month, then your pension payment would be increased back to $3,000/month if your spouse dies before you. Plans generally terminate the pop-up protection after a pre-determined number of years…i.e., 5 years. In other words, if your spouse dies in year 6, you will be stuck at $2,700/month for the rest of your life.
You Die Early in Retirement
This is precisely why you elect a J&S Option – to protect your spouse. You die, and your spouse continues to receive income. The death benefits from a life insurance policy, however, can be used to supplement income or buy an annuity at the time of your death. A little homework must be done up front to determine the amount of life insurance that is needed to purchase the same annuity (i.e., $1,350/month to continue our example). But this can easily be calculated by a financial professional familiar with these issues, if appropriate.
Whew, that’s a lot to consider. This is an important decision. We’re here to help, if you have an upcoming pension election.
Bottom Line: Carefully consider your options with a financial professional and do not automatically elect the J&S Option.