At my age, money is … Part Two Pension Income by Bill Storie

RH Weekly Cover

By Bill Storie 

This is the 3rd in the weekly Series called Retirement Happiness. In this Series we discuss the issues and concerns about money, and how its various components are so inter-twined that sometimes we cannot see a solution to our constant fear of running out of money as we get older.

 Part 2    –              Pension Income

It is too wide a mandate for us to discuss the variety of national pensions across the globe, i.e. your State Pension. Therefore this Part addresses the pension you established during your working life i.e. your Private Pension.

Up to a few years ago the main type of private pension was the Defined Benefit Plan (“DBP”). This was where you, as an employed person, received a pension substantially funded by your employer, yet where you had the opportunity to contribute to your own pension as well. It provided a pension pay-out to you in retirement that was clearly “defined”.

However as the years passed and as the global economy matured and then declined, the DBP became less and less popular. The effect on your employer’s balance sheet became more and more of a concern – to the employer. A new approach had to be found.

While the Defined Contribution Plan (“DCP”) format had been in play for many years, it slowly became the preferred method by the employer community. It still provides a pay-out of course, but it is calculated on the contributions you and your employer have made into the pension pot over the years you have been employed. The difference between the DBP and DCP is substantially different – less cost to the employer, and broadly speaking less pay-out to you.

Looking at both types of plan today is academic in many respects. If you have a DCP then no point in calculating what would have been had you been in a DBP. Move on.

So, the issue becomes what type of pay-out method should be adopted at time of your retirement. Generally speaking there are two types of pay-out – (a) the Annuity method, and (b) the Draw-Down method.

Definitions :

  1. Annuity – A financial product that allows you to convert your pension fund into a regular monthly income that will last you for the rest of your life.
  2. Draw-Down – A regular monthly income from their pension fund while keeping the rest of the pension fund invested.

The difference is that in an Annuity, the pension provider takes your fund and calculates among other things, life expectancy, interest rates going forward and so forth and determines how much you will be paid until death. In other words, your funds have been “handed over” so to speak to the pension provider, and depending on the terms and conditions of the annuity, it is possible that your remaining fund at time of death does NOT come back to your estate. Whereas, in the Draw-Down, the remaining funds at time of death DO come back to your estate.

Easy decision you might say.

Maybe, but you must run the actual numbers with your pension provider to determine which method best suits your own personal circumstances. It is critical that you clearly understand the various options under the Annuity and the costs thereof. All Annuities are not the same. Make sure you have the details fully explained to you. For example, in one instance, you “hand over” your pension fund today, get hit by the proverbial bus tomorrow, and your estate never sees a penny. Buyer beware.

The Draw Down will normally have a residual value (unless you live way beyond your draw-downs) and that residual WILL get paid to your estate. There will probably be a maximum Draw Down, expressed as a percentage of your current value of the pension fund. So for example, if you start with $100,000 then in Year 1 you can withdraw say $7,000 (assuming a 7% maximum). Let’s say your pension fund does not grow through investment return for the year, then your fund will be valued at $93,000 at end of Year 1. Therefore Year 2 you will only get 7% of $93,000. Hopefully your fund will grow so there should be some re-building in the year to “recoup” part of the $7,000.

So, be very careful that you fully understand how your pension pay-out works and do not be led into a method which benefits the pension provider company more than it benefits you. Beware.

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