How to Diversify Your Company Pension
If your company pension plan (assuming you work for a company that still has one) supports a lump-sum distribution when you retire, you will be faced with the decision whether to roll over the pension into an IRA or whether to take it as an annuity (i.e. as guaranteed income for life). What many people don’t realize is that this does not have to be an “all-or-nothing” decision. You have the third option of taking the lump sum, rolling it over to an IRA, investing some of the cash, and using the rest to buy an immediate or a deferred annuity that will act very similarly to a pension. In effect you would be converting that single pension into a combined portfolio of investment assets – which can grow with inflation and can be passed on to heirs – together with guaranteed income.
Enabling this is a change to the Internal Revenue Code that now allows what the IRS calls qualifying longevity annuity contracts (QLAC) to be purchased inside an IRA. Annuities are like pensions in that they pay you a guaranteed amount of income over your entire lifetime (and optionally your spouse’s as well). A QLAC – more commonly known as a deferred income annuity (DIA) – is a type of annuity in which you pay the premium up front (e.g. at age 65) but don’t start collecting the income until a certain number of years later (e.g. beginning at age 75 or even age 85). Although you are limited as to how much you can contribute to the DIA within your IRA – up to 25% of the account balance or $125K, whichever is less – the IRS does not count the DIA premium as part of your IRA balance. That provides you with a nice tax break when you turn age 71 and have to begin taking required minimum distributions (RMDs) from the IRA. Your RMDs will be smaller than they would have been without the DIA in the account, and the tax on the distributions consequently lower. (Of course, when the DIA starts paying out, that income goes into your IRA and you will have to pay taxes on the full amount when you withdraw it.)
Why use a DIA rather than the more common single premium immediate annuity (SPIA), in which you pay the premium up front just like a DIA but start collecting the income immediately? Mostly because you get a much higher payout. In today’s low interest rate environment, SPIAs are returning around $6K annually for every $100K invested when purchased at age 65. A 20-year DIA, by contrast, currently pays around $65K per year (remember though that the payout doesn’t begin until you turn 85).
As with all financial choices, there are some caveats. First, there’s inflation. With any fixed payment over time, whether from a pension or an annuity, inflation will eat away at its value. If you retire at age 65, for example, by the time you turn 90 your annuity payment – even at a relatively mild annual inflation rate of 3% – will be worth less than half of what it was when you had signed the contract.
Next, there’s the question of whether or not an annuity should reside in an IRA at all, since they are both designed for tax deferral. Is it more tax beneficial to locate the annuity outside the IRA – i.e. in a taxable account – or inside? There’s been a lot of debate among financial planners on this topic in recent months and there is not yet any clear consensus.
The concept of guaranteed income is also worth some thought. If your employer should go bankrupt, your pension would be guaranteed by ERISA (part of the U.S. Department of Labor). An annuity, on the other hand, is guaranteed only by the insurance company that sells it. The National Organization of Life & Health Insurance Guaranty Associations (NOLHGA), an industry trade group, maintains a state-by-state fund to support insurance & annuities claims from insurers that go bankrupt. But it only applies to insurance companies that are members of NOLHGA. And both ERISA and NOLHGA have limitations on how much you can receive from a defunct pension or annuity. To protect yourself you might consider purchasing multiple annuities from different insurers to diversify the risk.
Ultimately how much of your pension should be put into annuities and how much into other capital market investments is a complex decision involving your current financial situation, your future goals, your risk tolerance, your tax situation, the availability of other sources of income, etc. Be sure to do the comprehensive planning before making such a decision.