How Do Pensions Work? Demystifying the Terminology

Selecting how to take their pensions is one of the top five life-altering financial decisions most people face. Despite the decline in pension plans in the private sector, there are still over 17 million private-sector employees covered by these defined-benefit plans. For government employees, they are still pretty much the norm, with over 14 million of the 19 million Americans employed in government covered by a defined-benefit plan. So how do pensions work? 

As retirement nears, workers covered by these plans must select an option for how to take their pension benefits. The selection of their pension distribution option has major and potentially life-altering ramifications for both the worker and his or her spouse. Some options have significantly higher monthly payout — yet fewer guarantees. The starting point for making the best choice is understanding how each option works — knowing what you give up for what you get.

Annuity Payment

Pension benefits are made as an annuity. This is a series of payments based on a person’s life expectancy. A pension is simply an annuity based on the life expectancy of the employee.

Further Reading: “4 Employee Benefits That Help You Save Money”

The Parties Involved

Even if you are single, there will be more than one party involved. Knowing the nomenclature is important. An annuitant is someone who receives benefits under an annuity contract. This is the person on whose life the payments are based. There can be more than one in the case of a joint life contract, as we will discuss shortly. Your pension will also name a beneficiary who will receive benefits, if any, upon your death.

Generally, you will name a primary and a contingent beneficiary. The primary beneficiary receives any available benefits from the plan upon your death, unless he or she has predeceased you. If this is the case, the benefits pass to the contingent beneficiary. Either the primary or the contingent can be multiple people. For example, your primary beneficiary might be your spouse and your contingent your children, who receive an equal share of the benefits should your spouse predecease you.

Annuity Versus Lump Sum

Employees may have the option of taking a lump-sum benefit from their pension. This is a one-time option to receive a pool of money that the organization would use to generate your pension benefit. Sometimes this is a good deal, other times not so much. Either way, it involves greater risk.

Further Reading: “Key Ages in Retirement Planning”

The organization administering your pension uses an interest rate assumption to determine the pool of money required to produce the benefit you are entitled to based upon your service to your employer. That interest rate assumption makes a big difference. Using a lower interest rate to determine the lump sum equivalent results in a larger lump sum. The current relatively low interest rate environment produces relatively larger lump-sum benefits.

Retirees who chose a lump sum generally roll over that payment into an IRA. The intent is to generate a larger return than the discount rate used to determine the lump sum, netting a gain — often quite a significant one. 

But there is more risk — a lot more risk. A pension benefit goes forever, no matter how long you live and no matter what the market does.

Taking a lump sum benefit shifts the risk to the retiree, sometimes with devastating consequences.

If the investments do not perform as necessary to produce the desired benefit on an ongoing basis, the employee could run out of money. There is also the risk of overspending. With the pension option you get what you get, no more and no less. With the nice fat lump sum sitting in your IRA there may be temptation to dip into that big pool of money, which is really dipping into your future. Overspending in the present, as always, will be paid for in the future. In retirement, that can be devastating.

Not every pension has a lump sum option. However, most have a number of options for how to receive your ongoing benefit.

Further Reading: “How to Choose a Retirement Distribution Strategy”

Single Life Annuity

A single life or straight life annuity is the simplest form of annuity payment. A straight life annuity pays a level for the life of the annuitant, who is the retiree. When the retiree dies, payments stop with no payments to a surviving spouse or to children.

This option is often the one with the largest monthly payout because there is no additional risk to the organization. You live, you get paid; you die, no one gets paid.

But this option involves more risk to the retiree’s family than other options do. Perhaps that is not important to people with no dependents. For those who have others depending on them for support, the risk is generally too great.

Joint and Survivor Annuity

A joint and survivor annuity makes payments during the lives of two people. This provides an ongoing benefit should the annuitant pass before his spouse. This is typically the default choice for married couples. Often a spouse must sign a release for the employee to choose an option that doesn’t provide survivor benefits.

Further Reading: “‘Should I Write a Will?’ and Other Awkward-But-Important Questions”

There are a number of variations to this option. A pension may offer one or multiple choices. It may offer joint and 100 percent to survivor, in which the benefit to the survivor remains the same when the first of a couple dies. 

However, it’s more common for the survivor benefit to be reduced at the first death. For example, a joint and two-thirds option pays a monthly benefit while both the retiree and the retiree’s spouse are alive. At the first death, the benefit reduces to two-thirds of that amount for the remainder of the survivor’s lifetime. But sometimes it’s joint and 50 percent; there are unlimited possibilities.

And there are costs. The joint and survivor option will pay a lower monthly benefit than a straight life option.

This is to compensate for the increased risk of needing to provide a benefit for not one, but two lives. The reduction to provide the survivor benefit varies, but will often fall between seven and 15 percent of the straight life benefit.

Life Annuity With Period Certain

A life annuity with period certain provides a benefit for the lifetime of the annuitant, but not less than the number of years specified in the period certain. For example, a life annuity with a 20-year period certain would provide benefits for the life of the annuitant. However, should the annuitant die before the end of the 20-year period, the beneficiary will receive the payments for the remainder of that period.

Further Reading: “Retirement Strategies and Estate Planning”

Naturally, this option will have a lower payment than a straight life option, again to compensate for the risk of providing the additional benefit. This option is still a big gamble in terms of providing for a survivor.

It does, however, extract a portion of an employee’s benefit for a beneficiary should a retiree pass away early. For example, if you are retiring as a single person and want to make sure that someone reaps the rewards of your hard work should you pass early in retirement, this is one way to accomplish that.

Installment Refund

How Do Pensions Work? Demystifying the Terminology. So your job offers a pension, but all the jargon surrounding it makes your head spin. We've got you. Check out this handy guide to learn how pensions work. #pensionsretirement #pension #pensionplanretirementAn installment refund or refund annuity option is somewhat similar to a period certain. In this case, rather than a number of years being the determining factor for a survivor benefit, the accumulated total of payments made to the retiree is.

If the sum of periodic payments made to the retiree exceeds the lump sum value at retirement, no further benefit will be paid to any beneficiary upon the retiree’s death. If the sum of periodic payments does not add up to the lump sum value at the time of retirement, the remainder of that difference will go to a beneficiary upon the retiree’s death.

The beneficiary will typically have the option to continue receiving payments until the total of that initial lump sum equivalent is reached, or to receive a smaller amount as a lump sum payment.

Further Reading: “The Lowdown on Employer-Sponsored Retirement Plans”

Pop-Ups

A pop-up option restores a pension to its full amount should the second person die before the annuitant. For example, a retiree selects a joint and 50 percent survivor benefit. Then her spouse passes shortly after she retires. The pop-up option restores her pension to its full benefit, as if she had selected a straight life option at retirement.

As always, there’s a cost. But this alleviates a big fear of many retirees: that they select a reduced benefit only to have their spouse pass before them, leaving them stuck with the lower benefit.

The Details Matter

This discussion is intended to arm you with a general idea of how these options work. The specifics vary from pension to pension. This is one of the largest financial decisions a person can have to make. You need to spend some time understanding the specific details of your plan and how they may affect your situation. That is the only way you can make an informed financial decision.

The Bottom Line

This decision is huge. Even if you are a number of years away from retirement, your assumptions around this decision affect your planning. Understanding what your options are and what they mean is a great starting point. You can employ a variety of strategies to transfer or mitigate the risk of a reduced pension benefit. But you can’t objectively analyze them until you have a clear understanding of the options in front of you.

No matter how far away retirement is, start planning and saving today. You can use tools like Blooom to make sure that you’re on the right track.

Further Reading: “When Might Be the Best Time to Start Saving for Retirement?”

The opinions expressed in this article are those of the author alone and do not necessarily reflect the official policy or views of CentSai Inc.

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