Leaving a job, for any reason, is a major life event. If you are also leaving a pension, the decision as to what to do with it can have lifelong consequences. The choice of accepting the pension benefit of a guaranteed lifetime income, or cash it out now in the form of a lump sum of cash is not as clear cut as you might think. There are several key factors to carefully consider that should tip the scales one way or the other.
What Is the Choice?
Employers that provide a pension plans typically offer exiting employees a choice between keeping the pension benefit intact, or allowing you to cash out the plan by taking a lump sum benefit.
If you are vested in your pension plan, meaning your length of service makes you eligible to receive benefits, you can expect to receive a benefit when you retire. Some employers have a tiered vesting schedule which makes you eligible for a portion of your benefit based on your length of service. For example, if the plan requires 20 years for 100 percent vesting and you leave after 10 years, you may still be eligible for a portion of your benefit. If you are leaving your job with only partial vesting, you may also be offered a partial lump sum benefit as an alternative.
How Your Pension is Calculated
The amount of your pension benefit is usually tied to your earnings and years of service. As an example, when you are eligible to retire, you could receive 2 percent of your average salary over your final five years with the company, which is multiplied by the number of years of service. The actual amount of your pension benefit should be reported to you in your annual summary of benefits provided by your employer.
How Your Lump Sum is Calculated
Your lump sum amount is calculated using actuarial assumptions and calculations. For example, if you leave your company after fifteen years and are eligible for a lifetime monthly benefit of $1,700, the future stream of that income will be discounted to provide a lump sum value in today’s dollars. A lump sum value for this type of income stream would be $50,000.
Which Did You Choose?
The real question is whether you would be better off with a guaranteed lifetime income benefit or a lump sum of money you could invest on your own. Generally, the younger you are and the longer you’re expecting retirement to last, the more opportunity your investments have to perform. For example, if you are 32 years old with 33 years to invest before retirement, you could invest for growth. If you were able to achieve a modest growth rate of 6 percent annually, your $50,000 lump sum would be worth $342,000 at retirement. That would allow you to purchase an annuity that could generate a guaranteed monthly income of $2,250 (the amount could be lower if you choose a joint and survivor payout option for your spouse).
The older you are or the closer to retirement you are, the less amount of time you have to allow your investments to perform. Should the stock market underperform for a number of years, your investments could generate less income than what would be available from the pension option. The main reason why you might consider a lump sum option is if your company’s financial position is on shaky ground. If your company should file for bankruptcy, it would likely terminate its pension plan and hand it over to the Pension Benefit Guaranty Corp. The PBGC will still make payouts, but at a potentially lower rate than you would receive from your company.
Regardless of your age, each option has its pros and cons. It would be important to study both options in light of your particular circumstances.
Pension Benefit Pros
- Guaranteed lifetime income means more predictability.
- You can choose to receive lifetime income that continues to your spouse after your death (for a reduced benefit amount).
Pension Benefit Cons
- If you leave your company, your benefit amount will not likely increase between the time you leave and your retirement date.
- With most pension plans, your benefit amount will not come with inflation protection, causing your fixed income to lose purchasing power over time.
- The lifetime guarantee of your income depends on your former company’s financial position although it is insured to a certain level by PBGC.
Lump Sum Pros
- You have the flexibility of investing for yourself based on your own investment profile.
- If you have a long enough time horizon, your investments could outperform the pension option.
- If you invest well, you could have assets remaining after your death to pass on to your heirs.
Lump Sum Cons
- The responsibility of creating lifetime income sufficiently falls squarely on your shoulders.
- Poor investment decisions or adverse market conditions could result in less income available throughout retirement.
- If you use any portion of the lump sum for reasons other than retirement (i.e., pay off debt), you could jeopardize your retirement security.
- If you fail to roll your lump sum proceeds directly into an IRA or a 401(k) plan, it will be taxed as ordinary income and, if you are younger than 59 ½, you will owe a 10 percent early withdrawal penalty.
When you leave a job, you may be ready to move on; but, if there is a pension benefit involved, you need to take some time to carefully consider all of the factors in choosing your options, including your circumstances and your retirement outlook. Your decision will be final and the consequences will last a lifetime. Your best course of action is to seek the guidance of a qualified retirement planning specialist.