Annuities, Pensions And 401(k)s in Retirement

Pre-retirement planning is particularly important now as millions of Baby Boomers in America are beginning the transition from work into retirement. Living in retirement comfortably demands planning in advance to meet financial requirements. Income to consider during this period includes Social Security, 401ks and pensions that may have been acquired during working years.

It’s possible you might be working for a company that still offers a traditional defined pension benefit plan in addition to a 401(k) plan.  Most of the errors in planning for retirement are those of neglect, omission or panic. Failing to evaluate an employer’s retirement options can be costly as benefits can be worth as much as a nice paycheck.

A pension which is structured as a defined benefit plan provides a predictable, secure amount of money to you for the rest of your life, beginning at a specified age. 

Retirement benefits for Defined Benefit plans are calculated by a formula.  These types of plans are very popular for workers because of the lifetime guarantee and because benefits can be calculated before retirement, but are becoming increasingly less popular with companies.  There has been a significant drop in the number of defined plans, from 95,000 plans in 1980 to around 40,000 today. 

The employer is responsible for making the required contributions to the plan so that it’s funded sufficiently to make the appropriate benefits available when required. As such, the employer decides where the funds will be invested. With a defined benefit pension, the longer you remain with the company, the larger your pension will be.

With the current climate surrounding the state of corporate pension plans, it behooves you to understand exactly how your pension is calculated to ensure that you’ll receive all of the benefits due you.

Many people are not aware of just how their pensions are calculated. With most pensions, the benefit depends upon such factors as the employee’s earnings, length of employment, the age when he or she begins collecting benefits, and the formula which the plan utilizes. For instance, the formula might use an average of your pay in the final three- to five years of employment.

If your only company retirement plan is a pension, the likelihood is that you cannot make the decision to take a lump sum or monthly income because that has already been made for you.  That’s because most pensions pay benefits only in the form of a monthly annuity; in other words, you’ll get equal monthly payments for the rest of your life.  Very few remaining pensions allow employees to take a lump sum.

A 401(k) retirement savings plan is structured as a defined contribution plan. The plan defines the amount of money that you can put into it and how much your employer will match, if any.

Future retiree’s income is a concern because most employees simply aren’t saving enough. The average amount of money in a 401(k) is $29,000 while the median level is only about $10,000. That’s not likely to help much if it’s the only money you’ve saved for retirement and don’t have a pension.

In a Defined Contribution plan, retirement benefits are not known, unlike a Defined Benefit plan.  There is “no formula” to determine what the retirement benefits will be.  Rather, the amount that a retiree can expect is very dependent on how much money has been invested and the performance of the investments.  In this case, the investment choices figure prominently in the type of retirement the retiree can look forward to.  In this type of plan, there is generally no lifetime guarantee.

A 401k is a retirement savings instrument that enables contributors to place money aside without facing tax liabilities. This vehicle is typically offered through employers and might include matching funds paid on an employee’s behalf by the employer.

Contributions to a 401k are tax deferred. This means that income taxes will not be charged on money placed in these accounts until they are withdrawn.

You can usually choose relatively safe, fixed-rate investments for your funds, or you can opt for somewhat riskier alternatives. This savings vehicle can gain earnings in addition to contributions if it is attached to such things as annuities, mutual funds, stocks, bonds or money market accounts.

You’re most likely to face the choice of taking a lump sum or a lifetime income if your retirement package includes a profit sharing savings plan or 401(k).  Though such plans usually pay benefits as lump sums, your company may allow you to convert your account balance into an annuity. 

The annuity option is to take the market value of the investments in their account, the value may be in the hundreds of thousands, and purchase an annuity.  Annuities are insurance products that provide a guarantee of income for a certain period of time or for your life if that income option is selected and are available from major insurance companies.

Pension payments stop at your life’s end (or the life of your surviving spouse), not at the end of the actuarial life expectancy that’s assigned to you at retirement.  If you or your spouse’s heritage contains quite a bit of longevity, you could possibly lean toward the annuity. Thus, an annuity could be a bargain if, of course, you manage to live longer than average. 

The most common types of annuities are life income, which pays you a certain monthly amount until your death; life income joint and survivor, which assures that if you die first your spouse will continue to receive a certain amount until he or she dies; and life income and period certain, which pays benefits for your lifetime or for a specified period, whichever is longer. 

Life-only annuities pay the largest pension amounts but are cut off at your death.  But be careful if you decide to use this option; it must be done correctly.  Under federal law, a married person is prohibited from choosing the life-only option without the written consent of his or her spouse.  So, you’ll need your wife or husband’s approval in order to implement this financial approach.  In doing so, it’s wise to obtain a notarized waiver of the joint-and-survivor option from your spouse.

The other options continue to pay your beneficiaries at the cost of reducing your income by 10- to 15% during your lifetime. But pension payments stop at your life’s end (or the life of your surviving spouse)  so when retirement’s finally here, and now you have a gut-wrenching decision to make: how to take the money. 

Since most choices open to you are irrevocable, if you choose incorrectly you’re stuck with the consequences for the rest of your life. Make sure that you understand the pros and cons of each of the retirement options listed above.  Only then can you choose the option that is right for you.

For those reasons, you’ll probably want to have an experienced financial planner or accountant help you run the pertinent numbers to determine what’s best for you, as well as keep you from being tripped up by the tax laws.