Exploring Pensions

Introduction 

Pensions are an investment tool offered to employees through their workplace intended for retirement. In simple terms, a company makes contributions to a pension fund and when one of their employees retires, they can begin to receive benefits from the pension. In this blog, we will look at a situation where a person has the option to receive monthly payments until his death or take a lump sum amount of money. We will compare the two options and explore different scenarios for when he would retire and start receiving his benefits.

Monthly Payments Option

            First, let’s examine the option of receiving monthly payments. The monthly payments are a set amount that will not change. Some pensions offer a Cost-of-Living Adjustment payment option where the monthly payments increase with the rate of inflation; however, in our situation that is not offered. This specific person can receive a Single Life Annuity amount every month until his death. Once he dies, his surviving beneficiary will not receive any more payments from the pension. If he wants to receive monthly payments but also leave his pension benefits to his surviving beneficiary, then he can take a Joint option. The Joint option allows a person to receive set monthly payments like the Single Life Annuity; however, if they die their surviving beneficiary would be able to receive the benefits of their pension. Naturally, the monthly payments would be less for the Joint options depending on how much one would want to leave to their surviving beneficiary. In our situation, this person has the option to take a Joint & 50% Survivor Annuity, a Joint & 66 2/3% Survivor Annuity, a Joint & 75% Survivor Annuity, or a Joint & 100% Survivor Annuity. The monthly payments decrease the more he wants to leave for his surviving beneficiary. If he dies, his surviving beneficiary will receive the benefits in the form of monthly payments as well. We will explore the specific dollar amounts of each monthly payment option for him later in this blog.

Lump Sum Option

The other option this person has is to take the lump sum amount out of his pension. The sum depends on the benefits earned by the employee. Once he takes the lump sum amount, he will not receive more money from the pension. It is a one-time payment, and it is up to him to manage that money until his death.

Introduction to Bill

With these two options in mind, let's explore who our person is and his scenarios for retirement. Let's name him Bill. He has three scenarios in mind. Scenario 1 has Bill retiring at 60, but not receiving payments until 64. Scenario 2 has Bill retiring at 60, but not receiving payments until 62. Scenario 3 has Bill retiring at 61 but receiving payments until 62. All these scenarios deal with different numbers because in each scenario Bill retires or starts receiving his benefits at different ages. Naturally, the longer Bill waits to retire and receive his benefits, the more money he will have to start with.

Scenario 1

 In Scenario 1, he can take a lump sum amount of $145,261.06 or he can receive monthly payments from the pension. The monthly payment options are Single Life Annuity, Joint & 50% Survivor Annuity, Joint & 66 2/3% Annuity, Joint & 75% Annuity, and Joint & 100% Annuity. Their monthly payments to Bill are $918.78, $837.42, $813.41, $801.92, and $769.30 respectively. If Bill were to pass away, the monthly payments to his surviving beneficiary would be $0.00, $418.71, $542.28, $601.44, and $769.30 respectively.

Scenario 2

            In Scenario 2, Bill can take a lump sum amount of $132,604.54 or he can receive monthly payments from the pension. The monthly payment options are Single Life Annuity, Joint & 50% Survivor Annuity, Joint & 66 2/3% Annuity, Joint & 75% Annuity, and Joint & 100% Annuity just like in Scenario 1. However, their monthly payments to Bill are $785.36, $723.51, $705.00, $696.10, and $670.69 respectively. If Bill were to pass away, the monthly payments to his surviving beneficiary would be $0.00, $361.76, $470.00, $522.08, and $670.69 respectively.

Scenario 3

            In Scenario 3, he can take a lump sum amount of $143,703.69 or he can receive monthly payments from the pension. The monthly payment options are the same as before. Their monthly payments to Bill are $851.09, $784.07, $764.01, $754.36, and $726.82 respectively. If Bill were to pass away, the monthly payments to his surviving beneficiary would be $0.00, $392.04, $509.04, $564.77, and $726.82 respectively.

Comparing the Scenarios & Options

            Now that we know Bill’s different scenarios and options he can choose from, we should run some data to compare. Let’s start by comparing the different options. The big question is, should Bill choose the lump sum or the monthly payments? Which will provide Bill with the most amount of value? The way we will compare the two options is by calculating how long the monthly payments will take to “catch up” to the lump sum. In other words, how many years of monthly payments will it take for the monthly payments option to become more valuable than the lump sum? Let’s take a look at the graph and data for Scenario 1 at a 3% fixed yearly interest rate.

Analyzing the Options

            We can gather a couple of things from this data. First, we see that the Single Life Annuity Monthly Payment Option grows at the fastest rate. Another thing we can see is that it is the quickest to “catch up” to the lump sum. These observations are due to the monthly payments being the largest for the Single Life option out of all the other monthly payment options. The big conclusion we can draw from this data is that Bill needs to live at least 17 years to get the most amount of value out of his pension if he were to take the Single Life Annuity option. Now, if Bill is a young retiree and he believes he can live those 17 years, the monthly payment options become more lucrative depending on what monthly option he wants. If Bill is older, or his health isn’t as good, the lump sum would be more attractive because Bill can ensure the full value of his pension will be received. Every retiree’s situation is different, and their wants and needs differ as well. Picking a monthly payment option or the lump sum option depends on these situations and wants and needs.

Analyzing the Scenarios

Next, what we can do is analyze Bill’s three different scenarios for retirement we outlined earlier. To do this we looked at all three different scenarios at a 3% fixed yearly interest rate and analyzed how long each option would take to “catch up” to the lump sum and Bill’s age at each of those points. We took the data and condensed it into the table you see above. What we notice right away is that Scenarios 2 and 3 are identical. Another thing to point out is that Scenario 1 takes the least amount of time to catch up to the lump sum for every option. So, in Bill’s situation, if he wants to take the monthly payment option, Scenario 2 or 3 would be ideal because it will take one year less for the value to surpass the lump sum due to when his benefits commence. Again, everybody’s situation and wants and needs are different so other scenarios might be better for Bill depending on when he wants to retire and start receiving his benefits.

Conclusion

            Retirement is such an important stage of life, and the correct planning and advising are crucial to getting it right. We hope this blog is an informative example of all the different aspects and situations one must consider when receiving a pension. Talk with a trusted advisor about your situation and your wants and needs so they can correctly guide and help manage your decisions.