I read a quote the other day that said, “The way prices are rising, the good old days were last week₁.” It made me chuckle, but unfortunately, it’s also a pretty sobering statement. The historically high inflation we’re experiencing right now seems to cause the cost of everything to rise by the day. Inflation’s long-term average of 3.27% would be a welcome change right now, as we sit at about 8.20% currently₂.
I repeated this quote to a long-term buddy of mine, Will, from Cataumet, when we met for lunch last week. Will’s worked for more than four decades as manager for a national construction company, and he wants to retire next summer. He’s saved diligently for years, carefully adhering to his budget, and living a modest lifestyle. He has been widowed for the last fifteen years and has no children, so his planning is less complicated than others. And even better, Will has a company pension – something that’s rare these days.
In fact, according to a 2019 report from the Federal Reserve, a mere 21% of Americans have a pension to count on in retirement and this figure continues to decline. What was once considered a key part of the “3-legged stool” for retirement (Social Security, Pension and Personal Savings), pensions have slowly been replaced by the defined contribution plan instead, such as 401(k) plan. The “good old days” of relying on a pension to supply you with guaranteed lifetime income in retirement is simply not an option for most Americans today. Now it’s up to you to fund your retirement plan – perhaps with a matching contribution from your employer if you’re lucky. This also means you must select and manage the investments within the plan and eventually turn that pile of money into income when you retire.
Will, on the other hand, is one of the lucky few who can rely on his company pension. It has been funded and the investments managed by his company over his forty-plus years of employment, and the plan guarantees him an income stream for life at retirement. His pension amount is based on his years of service, salary, and age at retirement. But it’s not that straight forward – Will still has choices to make about just how to take his pension, which we reviewed in detail. So this week with our time together, I’d like to dig into what it means when a pension matures and what you should consider before making a decision.
With most pensions, there are a number distribution options that you can choose from. For example, you can an income stream based on your life or that of your life and your spouse. You could also choose the Life with Period Certain, in which you receive lifetime income, but payments are also guaranteed for a minimum period of time in case you die quickly. The last option is taking a Lump sum payout. Instead of receiving a monthly income, you instead receive a lump sum that you invest in a separate account.
What option makes the most sense for you depends on a number of factors, but one key consideration is taxes. Pension plan distributions are considered ordinary income, not the usually more favorable capital gains tax rates. Each of the pension options above will create a tax liability, which reduces the money in your pocket, so it makes sense to review your options carefully before making a decision.
For instance, if you take the lump sum payout, not only is this ordinary income, but the payout could push you into a higher tax bracket. Depending on the size of the pension payout, it could also trigger additional investment taxes on other sources of income. And it could even reduce your eligibility for other tax deductions and benefits.
And while taking regular pension payments instead of the lump sum option may seem appealing, it isn’t always the best decision.
You see, pension funding is a big concern for many, and it was for Will. By relying on regular payments from your former employer, you are counting on them to fund the plan adequately. But what if they don’t? Many pensions have collapsed under financial obligations owed to retirees, and when this happens the government steps in to help cover these payments, but the payouts are often reduced.
Will decided to do a company to company transfer into an individual retirement account (IRA) as opposed to receiving the check in hand. He did this for two reasons, first to gain control of the asset, and secondly to help avoid a potential 20% withholding for federal tax liabilities. When Will transferred the lump sum into an IRA in his name, he now has almost unlimited investment options that a pension just does not offer. And for those who want to leave money to loved ones, you can withdraw the money you need for your retirement and leave whatever is left to your beneficiaries.
Folks, it is tricky out there so make sure you seek sound retirement advice; the kind of advice that helps to put you in the highest probability of financial success.
And as always – be vigilant and stay alert, because you deserve more!
Have a great week.
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, and Mansfield, MA.