5 Things to Consider With Lump Sum Pension Offers

The US Federal Reserve Bank came into existence in December of 1913 after Congress passed the Federal Reserve Act. The Federal Reserve had three primary objectives at the time – maximize employment, stabilize prices, and moderate long-term interest rates. While these objectives have changed over time, one of the primary roles of today’s Fed Bank remains to regulate interest rates. This activity by the Fed Bank is often watched closely by financial institutions and foreign governments, but the average person likely paid little attention to these changes in recent decades.

Since 2008, following the Great Recession, market interest rates have remained historically low. The target level for the Federal Funds Rate was 3.5% at the start of 2008, and was lowered throughout the year to a target range of 0% to 0.25%. It remained at this unusually low level for seven years, increasing slightly to 0.25%-0.5% at the end of 2015. Rates continued to gradually increase until the COVID outbreak of 2020 when the Fed decided to lower rates to near zero again. Today, we find ourselves in an economic environment not seen since 1994, where the Federal Reserve is increasing rates regularly and rapidly. With this much change in such a short period of time, financial institutions and foreign governments aren’t the only ones paying close attention.

The federal funds rate affects various market rates in the US. This includes US treasuries, certificates of deposit at your local bank, credit card rates, mortgage rates, and even premiums your insurance carrier may charge. If you have a pension through your employer, you may also know that interest rates can influence that. While many people don’t directly see the effects of interest rates on their pensions, for those with lump-sum rollover offers, the impact can be significant. When interest rates are historically low, the actuaries that calculate the value of pension benefits normally assume it will take more money to provide lifetime pension payments for a given person. Imagine if you had to purchase bonds to provide enough monthly income for your retirement needs. Generating a $1,000 monthly income from a bond rate of 1% requires $1,200,000, but generating that same $1,000 monthly payment at a bond rate of 4% requires only $300,000. While actuarial science and pension plan investment practices are more sophisticated than that example, it’s easy to see an inverse relationship between the assumed cash value of a pension and the market rate of interest.

Lump-Sum Pension Payouts

If your employer has offered you a lump-sum pension payout, it may be enticing to consider that option before their actuarial assumptions are updated with higher market rates. Hypothetically, a lump-sum payout would become smaller over time as market rates increase. However, taking the payout may or may not be your best choice. If a lump sum does turn out to be a wise choice for your situation, doing so before interest rate assumptions change could mean a significant difference in your payout amount.

Below are five things to consider if you’ve been given a lump-sum pension payout offer:

  1. Funding

    1. The ability of a pension to make payments to retirees for the rest of their lives (and possibly the rest of their spouses’ lives) is often only as good as the financial health of the pension’s assets. Pension plans regularly publish their funding levels to participants, which shows how well-funded the pension is relative to what’s owed to participants. A pension with a funding level of 90% generally means it has 90% of the assets needed to meet its liabilities to participants. Pension plans often invest their assets in bonds, equities, real estate, hedge strategies, private equity, and other investments to keep up with inflation and grow over time. The performance of these investments over time, plus the amount of money put into the pension from the sponsor (employer), will generally determine the financial health of the pension. Some pensions are well-funded while others are behind the curve. If you feel confident in your pension being around for the next 20-40 years or more, leaving it alone and foregoing the lump-sum offer may make sense. However, if you’re concerned about your pension’s funding long-term, a lump-sum rollover may give you control of the dollars instead. Keep in mind, the Pension Benefit Guarantee Corporation (PBGC) is a government agency that may step in to help when a pension is failing. PBGC benefits may or may not be the same amount as promised from the original pension.
  1. Control

    1. When it comes to investing your lump-sum dollars, you’re accepting the risk of how the investments perform. For some, that sounds terrible. For others, that sounds wonderful. If you have years of experience working with a fiduciary advisor or managing a portfolio of your own, you may welcome the opportunity to gain control of your pension dollars to manage as you see fit. Also, if you want your children to inherit these dollars one day, you may prefer the lump sum. With traditional pensions, you and possibly a spouse may receive monthly income from the pensions for the rest of your lives. However, if you pass away prematurely before enjoying much of these pension dollars, the pension plan generally keeps what is left of your benefit. With a lump-sum rollover to an IRA, you can pick both primary and contingent beneficiaries to inherit these dollars after you pass away. This offers more control for those who wish to leave an inheritance for family members or charities. Lastly, the lump-sum rollover may give you the option of liquidity in retirement. If you need a new car or a new roof, you can’t request “extra income” from a traditional pension plan. However, if those dollars are in an IRA, they can be withdrawn how and when you need them, including a monthly amount or smaller lump sums as needed.
  1. Longevity

    1. Do your family members tend to live well into their 90s? If so, assuming your pension is well-funded into the future, you may be better off with a monthly income stream than a lump sum. As you enter your 80s and 90s, you may not wish to have much exposure to the same types of investments you had in your 50s and 60s. A monthly income stream may offer the security you need, especially if you haven’t saved well for retirement. However, if your longevity is questionable for health or family history reasons, having cash may be the better option. If you like the idea of a lump-sum, but don’t like the idea of managing the dollars yourself, some people elect to use annuities with part or all of their lump-sum assets. Please note, some annuities pay a handsome commission to the advisor or agent selling them, while some annuities are low-cost and fee-based. How can you tell the difference? Ask and get it in writing! When it comes to low-cost annuities that don’t have a front-end load (commission), some offer guaranteed monthly income similar to the guarantees a pension may offer. Many of these annuities allow you to choose how to invest the money and also allow you to designate a beneficiary to inherit the assets after you’ve passed away. The downside is the cost. Annuities are provided by insurance companies. An annuity is essentially insurance protection wrapped around an investment account. The additional cost allows the insurance company to take on the risk of paying you income for the rest of your life. Annuities are highly complex, so be sure to read the materials well if you decide to use one.
  1. Fiduciary recommendation

    1. If you’re working with a financial professional, it’s important to understand that person’s motivations if they make a recommendation regarding your pension. Most financial professionals are compensated in one of three ways: percentage-based management fees, flat or hourly fees, or commissions. Some professionals are compensated in multiple ways, such as a fee for one service and a commission for another. Advisors that work for broker-dealers, or those with a Series 7 or Series 6 license, can often accept commissions on the products they recommend. This includes commissions from variable annuities. When an advisor is recommending that you roll your pension lump-sum into an IRA with them and they’ll receive a large commission upfront, it’s natural to wonder if any bias is at play. So, how do you know if an advisor can accept commissions? Look them up on this free regulatory website – https://adviserinfo.sec.gov/. If their profile shows they are an active “broker,” then likely, they can accept commissions. If you prefer to have recommendations from a fee-only fiduciary (a professional that cannot accept commissions of any kind on the investments they recommend), you’ll want to look for an advisor that is not a broker. If an advisor’s profile on the SEC website says “investment advisor,” they generally accept advisory fees for their services and act as fiduciaries. Keep in mind, some advisors are both brokers and investment advisors. If you want a fee-only fiduciary, pay close attention to this website. A fiduciary must make recommendations that are in their clients’ best interests, which may or may not be to roll a pension into an IRA.
  1. Tax planning

    1. Pensions generally allow a participant to collect monthly benefits as early as age 55 without incurring an early withdrawal penalty. If you retire between ages 55 and 59.5 and don’t have any other source of income to meet your needs, rolling a pension into an IRA would generally require you to wait until age 59.5 before being able to take distributions without a 10% penalty. Some exceptions can apply, such as disability or 72(t) distributions. Keep this age 55 rule in mind if you have limited outside assets and don’t plan to work until age 59.5. However, if you don’t need the money thanks to continued work or other assets, rolling a pension into an IRA would allow you to defer taxes until age 72. If you don’t take any distributions whatsoever until age 72, you may enjoy tax-deferred growth on these dollars. Once you reach age 72, annual required minimum distributions (RMDs) apply. This IRS rule is meant to begin paying Uncle Sam tax revenue on some of these pre-tax assets. However, this also opens an opportunity for a new tax strategy – the Qualified Charitable Distribution (QCD). If you’re charitably inclined, instead of gifting cash to your church or favorite 501(c)(3) charity, you can gift part of your RMD to charity. If done properly, neither you nor the charity would owe taxes on these dollars. If you plan on giving to charity, the QCD may be a great tax-advantaged strategy to help both you and the charity. The maximum QCD amount is $100,000 per year and you can technically use this strategy starting at age 70.5. Rolling your pension into an IRA may give you additional tax flexibility and planning opportunities.

As a bonus topic, if you decide to roll your pension into an IRA, remember that stocks and bonds aren’t the only types of investments you may have at your discretion. While not for everyone, you may also be able to use private investments that aren’t traded on a stock exchange. This means these investments may not be as liquid, but they also may not have the daily volatility inherent in the stock market. This may include private real estate, private debt, private equity, and more. A diversified portfolio may encompass an “all of the above” approach to asset allocation that includes both public investments and private investments.

Contact Moneta

If you would like advice from a fee-only fiduciary contact us. A member of our team will reach out to learn more about your goals and what may be best for your unique situation. Moneta is an independent, 100% partner-owned, fee-only RIA serving clients nationwide.

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