Before 401(k) retirement plans ever existed, many employers offered their employees pension plans. Maybe you even worked for a company that offered a pension plan before you started your own business. You work full time in and on your business, but maybe you’re thinking that it would be nice to have a little extra money coming in from that old pension plan. If you’re that business owner, and you’re wondering, “What do I do with an old pension?” continue reading. I have information to share with you.
Podcast Time Index for “I Have an Old Pension, What Should I Do With It?”:
- 01:14 – I Have an Old Pension, What Should I Do With It?
- 01:47 – What is a Pension?
- 02:50 – Who Offers Them?
- 03:21 – How Do They Work?
- 03:50 – Single-Life Option
- 04:13 – Joint & Survivor Option
- 05:03 – Period Certain Option
- 05:55 – Lump Sum Payment
- 07:14 – Fixed Annuity: Pros and Cons
- 10:02 – Lump Sum: Pros and Cons
- 12:06 – Do’s and Don’ts
- 14:54 – Wrap Up
How Do Pension Plans Work?
If you worked for a company or institution long enough to qualify for its pension plan benefits, then you will eventually reach an age of eligibility. Upon retirement, the company you worked for will pay you a pension – a monthly payment similar in size to the salary you received during the years you worked – until you pass away. Whenever you reach the eligible retirement age (specified by the pension plan’s guidelines), you will have pay-out options. You can take fixed, equal payments over the course of your lifetime, or you can take a lump-sum payout.
Fixed Annuity Options
If you choose the equal payment option or the fixed annuity option, you have more choices to make:
- Single Life Option – If you take this option, then you receive pension payments until your death, but no one receives benefits after you die. If you are single, this may be the perfect option for you.
- Joint and Survivor Option – If you take this option, then you receive pension payments until your death at which time your spouse will receive the same income payments until his or her death. The monthly income stipends you receive will be lower than what you would receive in a Single Life Option, but your spouse is guaranteed income for the rest of his or her life if you precede him/her in death.
- Period Certain Option – If you want your monthly income to be higher than it would be in the Joint and Survivor Option, but you want to take care of your spouse if you die before him or her, then a Period Certain Option might be right for you. In this option, you receive equal monthly payments until your death, but you can make sure that your surviving spouse receives those same payments for a “certain period” after your death. Maybe that’s 10 years. Perhaps it’s 15 or 20.
Lump Sum Withdrawal Options
If you reach the age of eligibility and you don’t want to receive fixed payments over the course of your remaining years, then you may choose to take a lump sum payout. In this case, the pension company will calculate what would have been paid to you over your (assumed) lifetime. Then, they’ll take an assumed interest rate and calculate what they would have paid you over that time. Finally, they will give you the calculated amount of money all at once.
Pros and Cons of Pension Plan Options
Both the fixed annuity and the lump sum pension plan payment options have pros and cons.
The Pros of Fixed Annuity Pensions
- First of all, with fixed annuities, you are going to get income on a regularly scheduled basis for the rest of your life. No matter what happens out there, as long as the pension is viable, you’re going to continue to get your stream of income for the rest of your life.
- Second, you are not responsible for investment decisions; the pension company is. You do not have to bear the burden of investing your money in particular stocks and bonds. The pension company is doing that on your behalf.
- Third, the Pension Benefit Guaranty Corporation (the PBGC) provides you with protection against the termination of a pension plan or the sale of your employer’s company. If your former company merges, sells out, or dissolves, the PBGC protects your pension through a deal similar to an insurance policy. Therefore, whether your company continues to exist or not, you will typically receive your promised pension.
The Cons of Fixed Annuity Pensions
- With a fixed annuity, however, your income is probably static. Many pensions did not include a cost-of-living adjustment (a COLA). Therefore, if you’re receiving $2,000 a month at age 65, you will still be receiving $2,000 a month at age 95. That makes you vulnerable to inflation, we call this “inflation risk”.
- Additionally, you could choose the wrong option and harm your beneficiary. What if you chose the Period Certain option with a period of 10 years thinking you would live to 85, but you died at age 65? Your spouse might only be eligible for benefits for 10 more years. Yet, what if he or she lived another 30 years?
The Pros of Lump Sum Pensions
- On the other hand, the lump sum withdrawal puts the money in your hands for you to make investment decisions. You can take control of your assets. You might be able to invest the money and make 8, 9, or 10%, whereas the pension company is only getting a return of 1 or 2%.
- Additionally, IF you roll your money from the pension company into your IRA, then your money continues to grow tax-deferred. You have the option to take the money as cash, but you risk paying major tax penalties if you do that.
- You’re protected if something happens to the pension company. Above, I talked about the pension company protection of your money if something happens to your former company. But what if something happens to the pension company? What if they’re underfunded?
- If you invest your funds well, there could even be an inheritance for your beneficiaries. See in a pension, once you and/or your spouse dies, the income ceases. However, if you take a lump sum and do not use all of the corpus, then the remaining funds are available for your beneficiaries.
The Cons of Lump Sum Pensions
- By taking a lump sum, though, you could also have difficulties. YOU are now responsible for providing yourself an income for the rest of your life. What if you spend the assets too quickly or make poor investment decisions? Would you have to go back to work to make money? Do you want to work at age 75, 80, 85, or 90?
- Also, you have to think about this. If you don’t roll the money into an IRA, then you’re immediately liable for paying taxes on that distribution. A large percentage of your distribution would then be “eaten up” by taxes, leaving you with less than you anticipated when you took the lump sum.
What Do Business Owners Do With an Old Pension?
So what do you do? If you have a pension AND you’re a working business owner, what should you do with it?
- WAIT. Do NOT take income from a pension while you’re still earning trade or business income. If you are still making money from your business AND you are earning income from a pension, you could create more tax liabilities for yourself. Instead, wait until you reach full retirement age before you start taking the fixed annuity payments. Let the funds accumulate longer for you. Don’t withdraw the funds early.
- Have your financial planner run a net-present value calculation IF you’re offered a lump sum buy-out. In other words, have your planner determine how much money your pension plan is earning now and how much money it has the potential to earn in the future. If your plan has a calculated 8.5 or 9% annual increase, you may want to leave the money in the plan and let it continue earning that money. However, if your plan is only earning a percent or a percent and a half, you may be wiser to take the lump sum and roll it into an IRA of your choosing that could potentially earn a greater return.
- Do NOT cash in a lump sum. Instead, roll it over to your IRA. If you cash in the lump sum, you could potentially face significant tax consequences. Roll over the proceeds from a lump sum offer into an IRA.
If you’re a business owner and you have a pension, your rules are different. You’re not playing in the same sandbox as non-business owners. Therefore, it behooves you to speak to a financial planner. Run the calculations and see when and how you need to take income from the pension.
For more Cash Flow-related articles dealing with Business Owners’ finances, visit the Cash Flow category.