All entrepreneurs are created differently. Some were born as business owners, others adopted it as a second “professional life”. For those career changers starting (or growing) their business, their financial plan from their previous life can make things more complex. Specifically, many entrepreneurs retiring from their first profession with a pension have to decide whether to take a lump sum or pension payments for life. While it may not be an easy choice, the best decision for a pension retirement plan can have a lifelong financial impact.
Understanding Pensions
Many new and soon-to-be business owners are career changers with retirement plans from a past life. I’ve written an article on retirement accounts like 401k’s at previous employers, but a pension plan is a different situation. While pensions have decreased in popularity in the last few decades, many still face how to maximize this retirement plan. If your next life phase is to run your own business, decisions today for the future become especially difficult when you start projecting what the business and your life will look like.
Many of the old-school pensions were simpler than those in circulation today. There were no lump sum options, “10-year certain” periods, or 5-10 other options that all sounded the same. Once retired, the company would pay a fixed payment each month until the retiree passed away. Most of the pension plans I have seen now offer many different options. I talked to a client this month with 19 different pension options. Each company’s version may be slightly different, but the main options follow a similar theme:
- Basic/Single Life Annuity- the “old school” version, fixed monthly payments for the life of the retiree.
- Joint and Survivor Annuity- fixed monthly payments for life, with some percentage continuing for the spouse after the retiree’s death.
- Period Certain- fixed monthly payments for life, with a guarantee of payments for a period of time, regardless of whether the retiree dies.
- Lump Sum Option- a one-time payment of a partial amount or the entire pension value.
The fundamental issue with a pension is the value of the pension is dependent upon the life of the retired employee. Employees who paid into the pension for decades only to die after 1 year of payments would have lost significant amounts of money. Therefore, each option allows you to “capture” some value to offset the risk that you pass away early.
The two primary options to consider are the survivorship status and the lump sum option. Survivorship options allow a spouse to take a percentage of the pension after you pass, and therefore payments will last until both of you pass away. Most married couples prefer this, as it allows them not to worry about who dies first. The other option is the lump sum. Pensions run actuarial studies to predict when a retiree will die and offer to “payout” the pension altogether to remove it from their books.
Entrepreneur’s Dilemma
While deciding the right pension option is significant for anyone, new business owners have an especially difficult job. Typically, income planning in an oversimplified way is about understanding your expenses and living within your income. Those who are confident in the cost of their lifestyle can better understand the impact of a higher or lower pension payment. New business owners, on the other hand, cannot as easily rely on their future income, since it is dependent on the success of the business.
Retirees turned entrepreneurs must manage the start-up costs and expenses of starting and running a business. It would be an understatement to say cash flow would be irregular for months or even years. As a result, the lump sum option of a pension becomes more appealing, as money could be put to work to help fund the business. While that could be the case, pensions were designed for retirement, not necessary to fund a company, and could mean serious tax consequences if used incorrectly.
Most pension plans are pre-tax buckets of money, so a lump sum option is not a tax-free check to deposit into your bank account. Instead, it is more like taking the value out of a pension and into another retirement account like an IRA. Many of the retiree entrepreneurs I work with are in their 40s and 50s, well before when the IRS “thinks” you should retire. Moving any part of the pension into an IRA for a 40-year-old means that money is relatively untouchable for at least 20 years (without paying taxes and penalties). This creates a significant drawback for the lump sum option since the basic pension payments do get deposited into your bank account and can be used for living/business expenses.
The Right Decision
Pensions mathematically produce each option, so while impossible there could be a more objective answer if there was complete information and no subjectivity. When looking at lump sum options, focus more on whether the original pension offer can be recreated. For example, imagine a retiree is offered a $1,000,000 lump sum or a $5,000/month payment for life. Dividing $5,000/month from $1,000,000 would be a 6% annual distribution rate ([5,000*12] / 1,000,000 = 0.06). In this hypothetical scenario, the retiree taking the lump sum check would want to generate at least a 6% annual return to “recreate the pension” for life. For those more tolerant or accepting of risk, that may be a good deal. Others would prefer a lower bar to meet and would take the pension payments instead.
Most likely, there is no right choice when picking one of the options. Similar to buying a new car or house, you will only know if you made the right choice years after you decided. The unique financial situation that each retiree entrepreneur faces changes the probability of success for each option. For those who are more accepting of risk, it may be more beneficial to take a lump sum. Those retiring at a younger age may have too many restrictions on the lump sum to see it as worthwhile. New business owners may be less confident in their future cash flow and may “sacrifice” any potential higher gains of a lump sum specifically for the security of guaranteed payments.
This is why working with professionals is so important. An accountant and advisor should explain not only the requirements to get the business off the ground but also how the different options affect your tax status. Taking a large tax penalty for distributing a lump sum pension can cost thousands of dollars of avoidable taxes. A financial planner should help you relate each specific decision (like which option to take) back to your overall financial plan. Whether you take a lump sum or a payment is just as much of an estate planning or business planning issue as it is an income issue.
Plans Change
Understanding the different pension options can be challenging and making one decision that will impact the rest of your life can be overwhelming. Focus on understanding your entire personal and business financial plan and make the best decision you can. You will never have all the information and that is okay. Retiring and starting a business can be filled with excitement, and when done correctly, your previous professional life can dramatically support the next chapter of your life.
TC Falkner 