Some employers offer a pension benefit which is a fixed income that is paid during retirement. This may be in addition to Social Security or in place of a Social Security benefit.
Money is funded into the defined benefit plan by the employer, and sometimes by the employee too. The money contributed into the plan is a tax deduction for the contributor, so it “qualifies” for a tax deduction.
Typically, the plan benefit is defined (that’s why it’s called a defined benefit!). The formula is typically a matrix that uses years of service on one axis and the person’s age on the other axis to provide a percentage of their income that will be paid at retirement. Sometimes the formula uses the highest 5 years of income, but some use lifetime average.
At retirement, the employee may be offered a series of payments or a cash amount that they can take instead of receiving monthly payments. This lump sum is typically rolled over into an Individual Retirement Account (IRA) as a non-taxable transaction.
Once the money is in the IRA account it can be invested the way the retiree feels is appropriate. This has a benefit of having all of your money up front, so if you want to remodel a bathroom, you can take a withdrawal for the expense. But there is a downside; if you run out of money, it’s gone.
The other method of receiving a pension benefit is to receive a series of payments. Pension benefits are typically calculated under a single life expectancy. This means that the payments are based upon the retiree’s life expectancy and when they die, the payments stop.
If the retiree needs to be sure another person is cared for during retirement, they may elect to take a joint survivor payment. Under this option, when the retiree dies, the surviving person will continue to receive some form of payment. The payment amount is decided when the retiree elects how to receive the pension payments.
Lump sum: $1,300,000
Single Life payment: $5,000 per month
Joint survivor payment with 50% payment to survivor
$4,000 per month with $2,000 per month to the survivor
Joint survivor payment with 100% payment to survivor
$3,000 per month with $3,000 per month to the survivor
There can be several options to consider, and it can become confusing quickly, because they all appear to have certain features and benefits.
So how do you maximize the amount that you receive?
Remember that any joint survivor benefit is actually a single life payment with a form of life insurance. Yes, it’s life insurance. It is a benefit designed to leave money to someone after you die, which is life insurance.
Typically, life insurance has a cost that is associated with how healthy you are when you apply for the coverage. But taking a joint survivor benefit doesn’t require a medical exam, the price is built in based upon the person’s age. Ultimately, it may not be a cost-effective way to provide a benefit to the survivor.
Also, what if the spouse dies before the retiree? Typically, the retiree still has the joint survivor amount payable each month. They may be paying for a benefit that won’t be used. (Some plans allow for “reversion” to the single life payment, but not all plans provide this benefit)
What if you have saved enough that if the retiree dies shortly into retirement, the survivor will still be fine. Maybe they have their own pension and savings.
But how do you know for sure? How do you know which option to take at retirement?
The financial planning process helps uncover the many options available. By working with a competent financial advisor, the mathematics behind all the possible scenarios is solved and alternatives can be provided. Remember, this is a decision that is made and then it’s fixed in place, so it’s important. Don’t try to figure all of this out by yourself, ask for help!