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Blog | The Portfolio Doctor

The Portfolio Doctor

My blog provides valuable insights into Nobel Prize winning financial strategies for investors. By utilizing decades of worldwide peer-reviewed capital markets research and analysis, I demonstrate how to build better investment portfolios with lower risks. I also examine common financial media misinformation and how investors can make better financial decisions.

Choosing the Right Pension Option for Your Unique Circumstances

If you are nearing retirement and a pension is part of your retirement income, then you are likely considering how you might like to take that distribution. How you choose to receive your pension is a big decision, not only because it can have a big impact on your potential income, but it can impact your spouse and your family as well. If you have options when it comes to how you receive your pension, it is critical that you carefully weigh the pros and cons of taking a lump sum versus the annuity distribution option before you make a permanent and irreversible decision.

Taking a Lump Sum

Many people like the idea of taking a lump sum because it presents them with immediate freedom of choice in what they do with their money, when and how they wish to spend, invest or gift it. For many, with proper investment management, the lump sum has growth potential that can serve as a vehicle for increasing your retirement assets even after you retire.

It is important, however to consider the risks that are involved in taking a lump sum. We are all human and having access to a lump sum of money can make it easy to spend it too quickly. There is also the risk that the money is managed poorly or not invested properly. When investing a lump sum pension it is extremely important to consider time horizon and risk due to the fact that the lump sum is likely an asset that you will need to draw from at some point in your life after retirement.

The Annuity Option

There are a fair amount of advantages with an annuity payout and most speak to stability and known constants. An annuity option typically comes with guaranteed income for life. There is peace of mind in knowing exactly how much will be coming in each year and for how long. Additionally, especially for those who are risk averse, there are no decisions to make regarding investments or concerns to have when the market does poorly.

The grass, however, is not always greener. If you have a large pension, a portion of your future benefits guarantee is based on the financial stability of your employer. So, if there is a situation where the fund is not properly managed or your employer goes into bankruptcy your benefits could be significantly reduced in the event of that happening. What is also a serious consideration for those making the decision to take an annuity option is that there is a cap on what you can earn from your pension based on your income. For high income earners you may receive less over the life time of your annualized pension payments depending on where the cap is set. Lastly, if you have any intention of leaving money to your heirs (an your main source of post retirement income is your pension, the annuity option does not pay out to heirs in your estate other than spouses.

There is also no protection against the rate of inflation. A fixed monthly amount over the course of 20, 30 or 40 years has a low likelihood of keeping pace with inflation. If we look at the image below we can see what happens to prices to adjust for inflation over time.

pension options inflation

Over time, a well invested portfolio has the potential to grow in excess of the inflation rate which would put you in a better financial position. In order to weight the pros and cons of these choices fairly you really need to look at what other sources of income you have, how much you’ll need to live comfortably and securely in retirement and what other financial goals you have like providing financial support to grandchildren, making a large purchase like a second home, donating money to charity or leaving a financial legacy in your estate.

When it comes to choosing a pension option that is suitable to your needs there are several other factors that should not be overlooked.

Social Security

Many teachers and people who work for the state or federal government are not eligible to receive Social Security benefits. They are also not eligible to receive spousal benefits. If you were the main earner in your family and you are ineligible to receive Social Security benefits, then your spouse will receive little or no Social Security income (depending on how much they personally paid into Social Security).

It is also important to note that although private pensions are not factored into Social Security benefits calculations, taxable private pensions could boost your income to high enough levels that some of your Social Security benefits might become subject to income tax.

Delaying your Start Date

If you decide that taking the annuity option for your pension distribution (or if it is the only option) your company may provide incentives, similar to Social Security, if you delay benefits. Many companies are now offering higher payouts if workers decide to delay their payments.

Know How Your Pension is Calculated

While you are still working, it is important to have an understanding of how your pension is calculated. There may be opportunities to manipulate or boost your pension earnings by accepting a promotion or a raise. Many people, if they stay in a particular position for a long period of time, do not wish to change positions or don’t think of applying for promotions. It is important to think strategically about your career especially when it comes to saving for retirement and what it could mean for your pension.

Consider your Spouse

Would your spouse have enough income/assets to live the life you hope for if you were to pass unexpectedly? This is critical for high-income earners who might have a greater challenge saving enough for retirement to satisfy the same lifestyle that they had pre-retirement as many retirement savings vehicles have income caps. When a spouse passes away, often it is not considered what might happen to income versus expenses after their passing.

Whether it’s best to take a lump sum or to keep monthly pension payouts really depends on your personal circumstances. It will be important to assess your total retirement income (Social Security, 401(k), IRA, rental property income, etc), essential expenses, longevity of both you and your spouse and your wealth transfer plans. If you are presented with the option of taking a lump sum benefit from your pension plan, consult an expert who can give you unbiased advice about your choices.

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