If you’re working for a company that has an old-fashioned pension plan and you intend to retire sometime in the next five years, here’s something your employer would rather you not think about:
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You should jump the gun and retire today.
Many defined-benefit pension plans allow employees to choose to receive all the retirement money they’ve earned over the years in a single lump-sum payout when they call it quits – instead of receiving set monthly payments for the rest of their lives.
And with interest rates at historic lows, there will never be a better time than right now to get the most out of that lump-sum payout. Not only that – and this is what your employer really doesn’t want you to know – retiring and collecting a lump-sum payout now could protect you from seeing your pension blow up if the plan becomes underfunded in the future.
An old-fashioned, “defined-benefit” pension plan is different from a 401k plan, where an employee contributes a percentage of his own salary into a retirement plan, and sometimes the employer matches a portion of it.
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With a defined-benefit pension plan, the employee makes no contribution from his salary. Instead, his employer puts away a determined amount of money into a general fund from which the employee will receive a monthly check in his retirement years.
Exactly how much is determined by the Pension Benefit Guaranty Corporation, a government agency that factors in how many years worked, the employee’s age and other multipliers that differ among companies. The PBGC calculation results in a guaranteed monthly benefit that a retiree will receive for the rest of his life, whether he lives to be 70 or 110.
You may think a monthly check sounds like a good deal, but consider this:
Your monthly pension check is predetermined, and the PBGC calculation is based on the prevailing interest rate when you retire.
If the interest rate is very high, good for you. You get to lock in a high monthly pension check. If the interest rate is low, you lock in a low monthly check.
But if the interest rate is low, your employer has to set aside a larger lump sum when you retire just to cover it. And that high lump sum can be yours now.
Interest rates today are about as low as they can get, and they’re expected to stay low for the near term. So as you approach retirement, here’s your choice:
Grab a high lump-sum payment now, or lock in a low monthly pension check for the rest of your life.
That’s a no-brainer.
And there’s more. If you retire with a fixed monthly benefit check, you’ll get to watch inflation eat away at it every year, because your pension, at best, will have very small cost-of-living increases.
If you receive a monthly $2,000 pension check in 2014, you’ll get close to the same $2,000 a month in 2034 – when inflation will have eroded the value of that $2,000 to about $1,121 in buying power.
Fortunately, there’s a way to avoid this double-whammy of inflation and a low monthly check created by low interest rates. It’s the lump-sum payout, and most defined-benefit plans are required by law to offer you one, even though they’d very much prefer that you don’t take it.
Some plans permit you to withdraw all the money the company has set aside for you. Others let you withdraw all the money you would have been paid had you elected the monthly benefit, meaning you can score 20 or so years of monthly benefits all at once.
And then, instead of relying on a low monthly check that has been calculated based on a low interest rate, you can take that lump-sum payout and invest it in an Individual Retirement Account (IRA) that is tailored to fit your personal risk profile, with its own set of investment goals and with a much higher rate of return.
With that IRA in place, you can aim for returns that will exceed inflation and arrange to withdraw money only when you want or need it. You’ll pay income taxes only on the money you withdraw, and you won’t be tied to the constantly eroding value of a defined monthly pension check.
It’s a win-win, and it will be especially good for you when interest rates inevitably rise, as the interest you earn on your fixed-income investments will go up, too.
There’s yet another reason to take that lump sum, one your employer would rather not talk about.
Some companies, states, cities and municipalities have underfunded their pension plans, meaning that even if they continue to set aside money for each employee and invest it, the plan will run out of money at some point – leaving some retirees high and dry.
The PBGC is supposed to guarantee those pensions, but if many pensions become unable to meet their obligations, it will have to pay out trillions. And since the PBGC is a government agency, those payouts will come out of taxpayers’ pockets. Or maybe they won’t come at all.
And with retirees increasingly taking advantage of the lump-sum payout, pension assets are being depleted, meaning the plans can’t invest their money and grow in size.
So it won’t be long before some plans seek to change the law to restrict or prohibit lump-sum payouts. It’s either that or risk insolvency.
All of this is why, if you have a fixed benefit pension plan, you should seriously consider taking the lump sum and retiring now.
If you feel it may be right for you, speak first with your plan administrator to find out exactly what your lump-sum payout will be. Then speak with your financial adviser.
As Rod Stewart said in “The Killing of Georgie”:
Never wait or hesitate.
Get in kid, before it's too late.
You may never get another chance.
Take the lump sum and run.