How to create a monthly pension in retirement

Now that the majority of employees can no longer look forward to a gold watch and company pension at retirement, most now will be depending on 401(k) plans to fund their retirement years. Upon retirement, there are a number of options available when the time comes to start tapping a 401(k): a lump sum distribution, periodic distributions, or a rollover to an IRA.

There can be advantages to choosing periodic distributions, either directly from an existing 401(k) or from an IRA after rollover. Theoretically, the bulk of the retirement investment funds will still be growing from gains on the underlying assets that will help retirees keep pace with inflation and minimize the chances of the money running out. However, a disadvantage is that those funds will face continued exposure to the gyrations and ups and downs of the markets and so could decrease in value. What is a retiree to do when faced with the twin risks of the possibility of not being able to withdraw enough each month to assure a comfortable retirement and the chance of running out of money before running out of years? An immediate annuity might be the solution.

What Immediate Annuities Are and How They Work

Immediate annuities are financial products where a person typically makes a single payment to an insurance or investment company and then receives in return a series of periodic payments (monthly, quarterly, or annually) over a defined future period. There are two types of immediate annuities, fixed annuities and variable annuities.

With a fixed annuity, the owner receives the same amount each period. With variable annuities, however, the payments vary since they depend on the returns on the annuity investments. For those with the goal of establishing a steady, predictable stream of retirement income, the fixed annuity would be the preferred choice.

The amounts of the payments from a fixed annuity depend on several factors:

The amount of the single payment (or premium) to establish the annuity.

The length of the payment period chosen (life or for a set number of years).

Whether a guaranteed payout period is opted for.

Whether any survivor options were included.

When purchasing an annuity, a payment period is chosen. The purchaser may for example choose to receive payments for life, payments for the life of the annuitant and a spouse or other survivor, payments for a specific number of years (termed a period certain annuity) or for a specified period with a guaranteed minimum number of payout periods. For example, a period certain annuity might be purchased for a 20-year period with a 5-year guarantee. In that circumstance if the annuitant were to die after the first three years, the payments would continue for the remaining two guaranteed years to a beneficiary.

Immediate annuity payments begin immediately, hence the name. For example someone making the initial payment (paying the premium) to establish an immediate annuity on a date in any month would receive their first annuity payment the following month.

Annuities Pros and Cons

There are both advantages and disadvantages associated with immediate annuities.

Advantages:

A locked in, steady stream of income of a known periodic amount.

Payouts can last for life.

Favorable tax treatment.

Simple since issuer is responsible for investments not the annuitant.

Payments can be higher than a retiree might be able to achieve on their own.

Low-risk investment as solid as the financial condition of the issuing company.

Annuity payments can serve as a complement to other retirement income sources.

Disadvantages:

Some annuities involve sales commissions.

If contract allows for surrender, surrender fees can be steep.

Unless survivor options are chosen, payments end at the time of death.

Fixed payments are a set and may not keep pace with inflation.

Despite the disadvantages, fixed immediate annuities can be a good choice for those who want to assure a steady flow of income during retirement that removes the uncertainty over whether enough money will be available to meet monthly living expenses or whether they will outlive their nest egg.

Where to Buy Annuities

Most major insurance companies offer immediate annuities. Chances are an insurer already used by a prospective purchaser for life insurance would be a ready source for annuities. In addition, many large investment companies offer them as well.

Annuity calculators exist on the web that can be used by those considering an immediate annuity to run “what if” scenarios using various initial premium amounts, payout periods, and options. There are also sites where instant quotes can be obtained that will show based on options selected just how much periodic payments would be based on the initial investment or premium amount.

Lump Sum Pension Payment

Retirees have to make a decision as to how to collect on their pension when it’s time to collect. It is simply like how to win roulette. One option is to take a monthly payment from the pension for life. The other option is to take all of the money out of the pension. Although immediate gratification may be tempting, there are many circumstances where a lump sum payout is not a good idea.

Advantages of a Lump Sum Pension Payment

There are cases when a lump sum payout makes a lot of sense. Some people need money for necessities such as medical expenses that require a big expenditure. The pension may be their only source of cash.

Another reason to take a lump sum is if the pension’s assumption of future interest rates is low. With lower assumed interest rates, the employer needs to put in more money into the pension. The lump sum payment may be worth significantly more than the value of the monthly annuity in extreme cases such as some executive management pensions where the employer uses a very low future interest rate.

A lump sum may also be a good idea if the retiree does not believe their employer will survive. Underfunded pensions from companies that are struggling may be subject to failing. Failed corporate pensions are guaranteed by the US Government’s Pension Benefit Guaranty Corporation (PBGC), but the maximum benefits are limited.

Taxes on a Lump Sum Pension Payment

To postpone taxes on a lump sum, the portion of the lump sum payment not needed immediately should be rolled into a tax deferred retirement account, such as an IRA. If the lump sum is not rolled over to an IRA, the retiree would likely pay taxes at the maximum federal and state income tax rate due to the size of the lump sum distribution.

On the other hand, a monthly payment for life tends to be taxed at a lower rate because the pension payout is spread out over many years.

Government Pensions Such as CalPERS

In some public pensions such as CalPERS, part of the pension account belongs to the government employer. If a lump sum is taken, the employer portion is not refundable to the retiree. The size of the employer contribution varies from year to year, depending on the investment performance of the pension. If investment results are low, the employer portion of the pension could be quite large.

With government pensions, some of them have generous benefits such as COLAs (Cost of Living Allowance) and 50% survivor benefits that cannot be bought as an insurance annuity without far exceeding the cost of the lump sum. Many of those benefits are funded by the nonrefundable employer portion. Those in generous government pensions should never take a lump sum, but of course not all government pensions are generous.

Retirees should take the time to contact an insurance company and price an annuity with the same features as their pension. If the cost of the annuity exceeds the lump sum, retirees should think twice before giving up their lifetime monthly pension payments for immediate gratification.

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