Higher interest rates are good for our cash and checking accounts, but not always good for pension holders. Rising interest rates have an inverse relationship with the lump sum value of a pension. As interest rates rise, the value of a pensioner’s lump sum could decrease. For this reason, I see more pensioners who want to take a lump sum do so now rather than waiting.
I also see annuity rates improving as interest rates rise, pushing annuity income potentially higher than pension income (see chart below). There’s a lot to consider if you’re currently on a pension. Let’s review.
Advantages and disadvantages of taking a lump sum
If you have a pension, you may be entitled to a lump sum – not all pensions have a lump sum option. The lump sum is a one-time payment that replaces the traditional single or joint pension income. The lump sum can be transferred to an IRA tax-free. Once in the IRA, the lump sum can be invested in mutual funds, stocks, CDs, an annuity, or most other investments (there are some limitations (opens in a new tab)).
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Here are four reasons retirees transfer a lump sum to an IRA, including the downsides:
- More control. If you transfer a pension lump sum to an IRA, you control how the money is invested and when to take distributions (or not). In effect, an IRA gives you more control over the retirement asset. Of course, you could deplete the account faster if you end up overspending, or the account may lose money if you invest in the stock or bond market. Conversely, if you don’t invest the lump sum IRA properly, i.e. stay in low-yielding cash or CDs, it may not grow as much as the pension.
- Money for children. A pension is first and foremost a retirement planning tool. Children are important, but not the only reason for making your decision. The nice thing about transferring a lump sum to an IRA is that children can inherit the remaining account balance upon death if they are primary or secondary beneficiaries. This is not the case if you opt for pension income, the income stops on the second death if you have chosen a joint option, there are no remaining assets for the children to inherit Keep in mind mind that children of a deceased parent must deplete the IRA account by 10 years, according to IRS rules (opens in a new tab). Also, IRA withdrawals are taxable as income, just like pension income (state tax laws vary).
- More growth potential. A pension is considered a conservative investment, typically generating returns of less than 10%. Low risk may meet your needs, but if you want more growth, you can move the lump sum to an IRA and invest accordingly. Of course, you can also lose money in the IRA, so you need to know what you’re doing if you choose to invest with an IRA.
- You never know with pensions. Pensions may be guaranteed by the Pension Benefit Guaranty Corporation (opens in a new tab), but up to certain amounts. While the warranty is comforting, I’m skeptical. The PBGC may change its rules and safeguards. Also, if you have a pension from a company that is struggling, being bought or sold, or going bankrupt, I’m afraid they will have to rework their pension offer.
Moving a pension to an IRA may not make sense if the pension payout ratio is higher than your withdrawal rate. You should also calculate the rate of return on your annuity and assess the trade-offs. A trained professional can also help you decide what’s right for your overall retirement.
A compromise? Buy an annuity with a lump sum
If you like the idea of guaranteed income for retirement, but don’t want to disinherit the children, now is the time to compare pension income with annuity income. Since interest rates rose this year, I have seen annuity payout rates increase, and more and more annuities are exceeding retirement income.
In addition, unlike a traditional pension income, the balance of the pension can be left to the children. Annuities have many payment options, including a “cash back” option that pays out the account balance to the beneficiary. The table below is a concrete example.
This client has an annuity with a lump sum payment option of $300,000 or a single life income option that pays $19,996 per year. If the individual dies at the end of year 10, they have collected $199,960 during their lifetime. The balance – $100,040 – is lost. Compare that to moving the lump sum to an immediate annuity with a cash refund. Not only does the annuity pay out more annual income, but if the client dies in the 10th year, the children or another beneficiary can inherit the remaining account balance of $100,040.
Kids aren’t the main reason for choosing a lump sum, but the idea of an annuity is like having your cake and eating it too – retirement income for as long as you and your spouse live (if you choose joint income), and the remainder of the account balance can be passed on to the children.
There are different types of annuities to consider. An immediate income annuity pays income now. A deferred annuity pays later. Personally, I lean towards using a fixed deferred annuity, which is conservative, like most pensions. It’s best to speak to an experienced, independent adviser who can help you navigate the choices.
What to watch out for with annuities
No investment is perfect. Annuity income is leveled for life, like a pension, and is generally not adjusted for inflation. There may be an option for an inflation-adjusted income, but the overall income is usually lower, especially in the early years.
There is also a credit risk. An annuity investor relies on the creditworthiness of the issuing company. For this reason, stick with a highly rated insurer and consider diversifying insurers – spreading some of the retirement lump sum across different companies.
Liquidity is another downside; some annuities carry early redemption penalties if you withdraw more than the expected income stream.
Finally, make sure you fully understand the fees. Some fees are variable, while others may be fixed.
“When the facts change, I change my mind,” said John Maynard Keynes, the great economist. Rising interest rates change the calculations for pensioners. If interest rates continue to rise, lump sums may not be worth as much as they are today. This is the perfect time to evaluate your choices.
Michael Aloi (opens in a new tab) is a Certified Financial Planner with 22 years of experience. For more information or a free review of your retirement options, feel free to email him at firstname.lastname@example.org
Investment advice and financial planning services are offered by Summit Financial LLC, an SEC-registered investment adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600. This document is intended for your information and advice and is not intended to be used as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting their independent tax or legal advisers. Individual investors’ portfolios should be constructed based on the individual’s financial resources, investment objectives, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not indicative 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 externally referenced information found in this article. 10282022-0778
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