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How pension plans pay out: What to consider when you're about to retire

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Ezra Bailey/Getty Images

Pensions are a retirement benefit offered by some employers that can provide a solid foundation for financial security later in life. To get the most from your plan, it's important to understand your pension payout options. Coordinating your pension payout choice with the rest of your strategy for retirement income sources will ensure you maximize its value.

Generally, you can choose a single lump sum or monthly payments. Let's review the choices and the trade-offs pensions present so you're prepared to make the best decision for you.

Pension plan distribution options

Most pension plans allow you to decide how you'll receive your benefits: all at once in a lump-sum or monthly payments. Each has distinct advantages and disadvantages to consider.

1. Single lump-sum payout

A single lump-sum payout gives you one large payment when you retire—you won't receive continued payments throughout retirement.

From there, it's up to you what you want to do with that sum of money. A common option is to roll it into an individual retirement account (IRA). If you do, that money is treated like any other money you've contributed. You can invest it for continued tax-deferred growth. As you withdraw money over time, it's subject to the usual IRA withdrawal rules.

Potential benefits of a lump-sum pension payout

  • When you take a lump sum, you'll get access to the entire balance at once, giving you the financial flexibility to use it any way you choose.
  • You can invest your lump sum and potentially earn a rate of return that may allow you to withdraw more than you would get from any of your monthly payment options.
  • With a lump sum, you can potentially leave much more money to your loved ones. Whether you roll the money into an IRA or take it as a taxable cash distribution, any remaining balance is transferred when you die.

Potential drawbacks of a lump-sum pension payout

  • If you decide to take the lump-sum pension distribution in cash, you'll have to include the full amount in your taxable income for that year, and you also could incur additional penalties.You'll want to consider the tax implications, particularly if it might change your tax bracket.
  • A common retirement concern is longevity risk—making sure your savings will provide you with enough ongoing income for as long as you need it. Taking a lump sum rather than guaranteed regular payments means you'll have to manage what you do with it carefully to avoid overspending and running out of money.
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Couple listening to financial advisor at home with laptop
Informal meeting with mortgage advisor, discussion, paperwork, agreement

Should you roll your pension to a Roth IRA?

For some people, rolling over pension money to a Roth IRA can be an effective way to help reduce future taxes and create financial security in retirement.

Compare pros and cons of this type of rollover

2. Monthly payouts

Monthly payouts typically provide you with regular fixed payments for life. Your plan may offer an annual cost of living adjustment (COLA) for inflation, but that isn't always the case. There are three standard monthly payout options:

  • Single life annuity. If you choose a single life annuity, you'll receive a fixed payment for life, but there isn't any provision for a surviving spouse.
  • Joint and survivor annuity. This option offers a lower payout in exchange for continued payments to your spouse once you're gone. The surviving spouse's payment is stated as a percentage of the payment you receive, such as 100%, 75% or 50%. The higher percentage you choose for the beneficiary's payment, the lower your monthly payment will be. However, these options can provide significant income protection for a surviving spouse.
  • Period certain payout. A period certain payout guarantees payments are made for at least the stated length of time. For example, you may have a joint and survivor annuity with a 10-year period certain. If you and your spouse both die before receiving 10 years' worth of payments, those payments will continue to another named beneficiary.

Potential benefits of a monthly pension payout

  • Because payments are guaranteed for life, you're protected from the risk of running out of money. Having a solid base of secure retirement income means you don't have to worry about poor investment returns or how long you'll live.
  • With a joint and survivor payout, the benefit extends to your spouse as well. The same way life insurance can protect your loved ones, a guaranteed pension payout can ensure your spouse is taken care of after you pass away.
  • If you participate in a private-sector pension, your monthly payments are backed by the Pension Benefit Guaranty Corporation. That means if the plan is unable to pay, the corporation will cover a portion or all of your benefit.

Potential drawbacks of a monthly pension payout

  • A rare but potential downside of pensions is that the employer may go bankrupt. If you've agreed to take monthly payments rather than a lump sum, this could mean difficulties in getting your benefit. As noted, the private sector is backed by a guaranty company, but it may not cover your entire amount.
  • It's also possible if you opt for payments and you pass away early, you—and your loved ones—could end up receiving a far smaller total pension payout than if you'd taken the lump sum.

Should you choose a lump sum or monthly payout?

Understanding the benefits of each type of payout is a great starting point, but certain situations may make one option more favorable than the other. Here are some potential scenarios:

Reasons to consider a lump-sum payout

  • You already have a significant amount of other secured income. For example, if your Social Security payments alone cover all your necessities or you have an annuity, you may not get as much value from additional guaranteed income.
  • You have insufficient liquid savings. If you have no other liquid assets like IRAs or 401(k)s, you may decide that the increased flexibility and liquidity of a lump sum has advantages.
  • You have a short life expectancy due to your family health history or a new illness or condition. You may be able to spend more from a lump sum knowing it doesn't need to last as long.
  • You prioritize leaving assets to your heirs. If your monthly pension payments stop upon death, the lump sum may be a better option to pass on wealth.

Reasons to consider monthly payments

  • You don't have enough other stable retirement income. It can be incredibly comforting to know that you have guaranteed income covering your basic needs in retirement. If your Social Security benefit alone doesn't do that, a monthly payout may provide significant relief.
  • You have a low risk tolerance. Because your payout doesn't rely on investment performance, it shields you from the emotional aspect of watching your account balance rise and fall with the market.
  • You think you may live a long time and are worried about the risk of running out of money.

Choosing the payout that's best for you

There's no one-size-fits-all answer for picking the right pension payout option. It depends on your individual circumstances. Understanding how each one could benefit you is a great start to using your retirement funds wisely.

Consider contacting a Thrivent financial advisor for guidance in finding the best solution for you.

There may be benefits to leaving your account in your employer plan, if allowed. You will continue to benefit from tax deferral, there may be investment options unique to your plan, fees and expenses may be lower, plan assets have unlimited protection from creditors under Federal law, there is a possibility for loans, and distributions are penalty free if you terminate service at age 55+. Consult your tax professional prior to requesting a rollover from your employer plan.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.