Pension Income Planning: Lump Sum or Monthly Fixed Pension

Retirement Income Planning - Know the distribution options for your 401k and monthly fixed pension now before you retire.

Do you ever feel overwhelmed by all the financial decisions for which you are responsible? Are you afraid that if you make one little mistake, it could have a severe impact on your retirement? If so, you are not alone. According to Prince & Associates, a leading market research firm on the private wealth markets in the U.S., the number one fear of nearly nine out of ten (88.6%) middleclass millionaires? (those with $1 - $5 million of investable assets) is running out of money during retirement. 'They are concerned about the potential to no longer be able to afford a lifestyle they have been accustomed to.'

It can be scary. And, to make matters worse, advances in medicine are enabling baby boomers to live longer. Whereas most baby boomer's parent's generally had no more than about 10 to 20 years to enjoy their retirement, boomers will enter retirement with an expectation of living possibly another 30 to 40 years.

So, if you plan on living a long time during retirement, it is helpful to know how much buying power $100,000 of retirement income today will have in 15, 20, 25 years. The following chart will help:

So the question becomes how to make your retirement assets last your entire life.

To figure that out, you first must understand where your retirement income will come from. According to the Social Security Administration, Social Security income will replace 40% of an average American's pre-retirement income, another 40% will be provided by company-sponsored plans, and the last 20% will be made up of personal savings and/or work. Our belief is that for most retirees Social Security will make up only 20% of retirement income, while 60% will be generated from company-sponsored plans including 401ks and defined benefit plans, and the last 20% will derive from savings and IRAs.

Most people have become increasingly savvy with regard to their 401k plans and their investment options. However, many remain unaware of their distribution options for these 401ks and monthly fixed pensions. We will focus this article on the availability of transferring a 401k plan into an IRA while one is still working and the income options of a defined benefit plan after retirement.

First, let's discuss the difference between a 401k plan, known as a defined contribution plan, and monthly fixed pensions, known as a defined benefit plan.

A defined contribution plan provides an individual account for each participant. Retirement benefits are based on the amount contributed by the employee and employer and by any expenses, gains, and losses incurred over the years. The employer always selects the investment programs, but the responsibility of building a successful defined contribution plan rests solely on the shoulders of the employee.

A defined benefit plan promises the participant a specific monthly benefit at retirement and states this as an exact dollar amount. Monthly benefits can also be calculated using a formula that takes into account a participant's salary and service. A participant is generally not required to make contributions in a private sector fund, but most public sector funds require employee contributions. Unlike defined contribution plans the responsibility of building a successful defined benefit plan relies on the employer's investment expertise. Participants rarely ever have a say in the investment decisions.

Although they differ considerably, both plans have one thing in common: 99% of the time the employer selects the available investments. This could be great for the participant, if the employer provides good investment programs. However, it could be disastrous to a participant's retirement if the investments under-perform.

So what can be done to allow for maximum growth in both plans?

Until recently the laws prevented participants from having access to their company-sponsored 401k plans until they retired. The laws have changed. Most companies now allow participants access to their money at any time, which means that they can rollover a certain percentage (set by the employer) of their 401k each year into their own IRA. This gives participants the ability to have these assets managed the way they want and allows them to select their own investment vehicles.

In the case of defined benefit plans, employees do not have the opportunity to choose their own investment vehicles until they retire. However, most are not aware of the payout programs available. By law, an employer must offer at least four different payout strategies, which may be added to or changed at any time at the employer's discretion. One option that is becoming more popular is the lump-sum payout. According to the 2003 National Compensation Survey, 48% of participants in a defined benefit plan had the option of receiving a lump sum versus only 23% back in 1997.

There are two main reasons that lump sums are becoming more popular. The first is that employers would prefer to pay employees 100% of their benefits at retirement and be done with them. The second is that most employees want to be able to control their own money. If the employer makes bad investment decisions or the company runs into financial troubles in the future, the employee's monthly pension benefit can be reduced. Imagine the following scenario: You receive a $75,000 per year pension when you retire, which in 15 years will have a buying power of $41,201. Your employer runs into financial difficulties and has to turn the plan over to the PBGC, so your pension is cut to $45,000 (see article on page 1 to understand why), which equates to about $24,720 of buying power. You wouldn't be too happy would you?

Thus, the idea of taking a lump-sum distribution and rolling it over into an IRA is very attractive, because it gives employees full control over their retirement assets and allows them to do better legacy planning. Many retirees have specific legacy objectives and plans. It is easier to create a legacy strategy when benefits are within an IRA versus in a defined benefit plan. Even though defined benefit plans offer survivorship options, they cannot be changed once selected. So, if an employee's personal situation changes after retirement, he or she is out of luck.

So what should you do with your 401k and/or defined benefit plan? An idea that is gaining popularity among many 'new' retirees is creating what we refer to as a Super IRA. A Super IRA is a traditional IRA that consolidates multiple 'qualified' accounts into one.

When we say 'qualified' we mean 401ks; TSAs; pension plans; Keoghs; 457s; and SEP, traditional and simple IRAs. 'Non-qualified' accounts, including a spouse's assets or a Roth IRA, however, cannot be transferred into a Super IRA.

According to a recent survey by Columbia Management, almost 50% of respondents had at least three 'qualified' accounts. Many were unaware of the numerous advantages of consolidating these accounts into a single Super IRA, which include:

• Increased investment buying power
• Availability of more sophisticated investment strategies
• Reduced fees
• Beneficiary organization and consolidation
• Ease of transfer to spouse at death
• Streamlined paperwork and fewer statements
• Simplified retirement income planning