1 FRS Pension Payout Options The income distribution option that a Pension Plan participant chooses is easily one of the most important financial decisions they will make in their life and, potentially, in the life of their beneficiary. Unfortunately, FRS Pension Plan participants frequently choose an income distribution option that is not the most suitable for their personal circumstances. As far too many participants now know, making the wrong choice can end in a financial catastrophe that is only fully recognized when it is too late to remedy. The income distribution option that is suitable for a participant and their beneficiary should only be determined after much contemplation and speaking with a financial advisor familiar with the participant s complete financial circumstances and the FRS Pension Plan. So while the information provided below cannot be taken as a specific recommendation, it should provide Pension Plan participants with a better understanding of their options and the importance of taking the time to make an informed decision. Option 1 Option 1 is perhaps the easiest to understand among the various options. Quite simply, it typically pays the highest continuous monthly benefit to the participant over the remainder of their life, with payments ceasing when the participant dies. Due to the fact that no benefits are paid to a beneficiary, this option is sometimes overlooked by participants married to spouses without a pension of their own, or a non-spouse beneficiary that they would like to provide for after death. While this is understandable, it does not necessarily need to be dismissed as unsuitable under such circumstances; as will be covered while examining the other available options. Option 2 Option 2 typically pays the second highest monthly benefit to participants, and, if the participant dies, is guaranteed to continue paying the same benefit to the participant s beneficiary for the first 120 months 10 years after the participant s retirement date. Option 2 is one of the most frequently misunderstood options available to participants, and the most likely to lead to unanticipated financial hardship in the future. Sadly, many participants choose this option after receiving poor advice, not fully understanding the option, or both. This option seems like a reasonable compromise. It is usually pays a benefit that is around $100 a month less than Option 1 for the average, full retirement participant. This leads participants to
2 rationalize that they are not sacrificing too much benefit for the comfort of knowing that, if something were to happen to them, they would not be leaving their beneficiary completely empty handed. What many participants that choose this option do not fully understand is that the ten years of coverage for their beneficiary does not begin on the day they die, but on the day they retire. Many Pension Plan participants wisely take advantage of DROP for five years. When a participant enters DROP they have established a retirement date, and their chosen income benefit is deposited into their DROP account until their official termination date. For those that choose Option 2, this means that their overall DROP benefit will be reduced compared to Option 1, and, when they exit DROP, their beneficiary will only be covered for five more years. In a perfect world, this would not be an issue. However, in today s reality, many couples depend on a participant s full DROP distribution, as well as their pension and Social Security to maintain their standard of living into retirement. So if a participant dies even a day after exiting DROP, if they stayed in DROP for five years, their beneficiary only receives the income they were previously depending on to remain retired for five more years. If the participant dies five years after completing five years of DROP, the participant s beneficiary receives nothing. Without proper planning this can force a retired beneficiary that depended on this income back into the workforce. It would be a stronger option if the benefit were paid to beneficiaries for ten years after the participant passed away within the first ten years of retirement. However, the real drawback to Option 2 is the fact that the potential benefit to a participant s beneficiary is reduced the longer the participant survives beyond their retirement date. If a participant fully understands Option 2 and is still attracted to its structure, a similar, yet stronger, benefit can sometimes be established with a little planning. Depending on the participant s insurability, a participant can choose Option 1 and purchase a ten year term life insurance policy with a death benefit totaling ten years worth of benefit payments for an amount that is less than the difference between their Option 1 and Option 2 payouts. This translates into a participant s beneficiary receiving ten years worth of benefits based on the participant s date of death, not retirement date if the participant dies within the first ten years after retirement. If the participant lives beyond ten years, the insurance premiums cease and the participant continues to receive the higher benefit associated with Option 1. However, if the participant dies after ten years, when the insurance has expired, the beneficiary receives nothing; similar to if the participant had chosen Option 2.
3 Establishing this type of plan carries the same risk as choosing Option 2, but with greater potential benefits than can actually be achieved through Option 2. It is critical for a participant to determine their insurability prior to making a decision. This avoids a situation in which a participant chooses Option 1 with the intention of providing benefits to beneficiaries through life insurance, only to discover that they are uninsurable after making an irreversible decision. Option 3 Option 3 provides a level benefit paid for the life of a participant and the life of the participant s spouse, or any person who is 25 years of age or older and incapable of self-support due to disability. If the participant s beneficiary is younger than age 25 at the participant s death, the beneficiary receives the participant s Option 1 payout until they reach age 25, at which point the benefits cease; unless the beneficiary is disabled, in which case the beneficiary receives the participant s Option 1 payout until they are no longer disabled. While the description of the option itself might seem a little confusing, making the decision whether or not to choose this option is usually not as complicated. With this option, the monthly benefit is calculated based upon the ages of both the participant and their beneficiary in a process that is similar to determining the benefit of a joint life annuity payout. The decision to utilize Option 3 can become more difficult, and more important, if atypical factors such as a young and/or disabled beneficiary are considerations. However, in most instances, the beneficiary is a spouse, and the level payments calculated can be easily compared and contrasted with the other distribution options offered within the context of a broader retirement plan. Option 3 is often a popular choice among married couples, as it provides an opportunity to prepare for the future with a relatively high degree of certainty. That is, regardless of if or when one spouse passes away, the monthly income payments will remain the same. Option 3 is frequently a good choice for uninsurable participants whose spouse depends on the steady income provided by the pension. However, many participants who choose Option 3 are insurable and could have created a stronger benefit, and provided for multiple beneficiaries, by choosing Option 1 and creating their own version of Option 3 outside of the system. Depending on the ages of both the participant and the beneficiary, the Option 3 monthly benefit is typically substantially less than that of Option 1. If the participant is insurable, an opportunity
4 is present for the participant to purchase life insurance coverage that will provide a greater benefit than Option 3 to the participant s beneficiary, or beneficiaries, at a cost that is less than the difference between the participant s Option 1 and Option 3 monthly benefits. In this situation, if the participant s beneficiary predeceases the participant, the participant can choose to stop paying the insurance premiums, thus increasing their net monthly income to reflect the full Option 1 monthly benefit; or choose to continue paying the premiums for the benefit of a new beneficiary. However, if the participant predeceases the beneficiary, the beneficiary receives a life insurance death benefit that, with proper planning, can meet or exceed the benefit that would have been received through Option 3. Furthermore, when the beneficiary passes away, it is possible to pass the remaining assets from the participant s death benefit to new beneficiaries children, for example which is not a possibility with Option 3. Executing such a plan is, of course, entirely dependent upon the insurability of the plan participant and insurance options available at the time. It is for this reason that it is of the utmost importance to determine a participant s insurability and understand the insurance options available prior to making a decision. Option 4 Participants choosing Option 4 are originally paid a higher benefit when both they and their beneficiary are alive. Upon the death of either the participant or their beneficiary, the benefit amount is reduced by one third of the original benefit and paid to the surviving beneficiary for the remainder of their life. The exception to this is with regard to a beneficiary under the age of 25. A beneficiary under the age of 25 receives the participant s Option 1 benefit amount until they reach age 25 and benefits cease, unless the beneficiary is disabled; in which case benefits continue to be paid until the beneficiary is no longer disabled. The two tier benefit of Option 4 is usually directly compared with the level benefit of Option 3 to determine which option provides the most suitable overall benefit within the context of the present benefit and the impact of the reduced benefit when either the participant or their beneficiary predeceases the other. Option 4 can be a little tricky on occasion. Like Option 3, the benefit amount provided by electing Option 4 is calculated based upon both the ages of the participant and their beneficiary. Occasionally, if the participant s beneficiary is substantially older than the participant, the original benefit amount paid through Option 4 can
5 actually be greater than the level benefit amount provided by choosing Option 1. Such an occurrence is an anomaly. It is nonetheless the reason that it was stated above that Option 1 and Option 2 typically provide the highest respective monthly incomes. Outside of this uncommon situation, and even within this situation, the variables are known and can be considered relatively easily within a broader Retirement plan. Much like both Option 2 and Option 3, depending upon a participant s insurability, a benefit greater than that typically produced by Option 4 can sometimes be generated by choosing Option 1 and utilizing insurance at a cost that is less than the difference between Option 1 and Option 4. The FRS Pension Plan instituted the options discussed above in an effort to offer the choice of providing the maximum benefit to a participant over the course of their own life, or providing an otherwise unobtainable level of financial security for the beneficiary of an uninsurable participant. However, it is unwise for participants to make the assumption that they are uninsurable, or to leap to the conclusion that they would be sacrificing less monthly income by choosing Options 2, 3, or 4 than the insurance premiums would cost to establish a similar benefit after choosing Option 1. In reality, it is frequently the case that a participant does not qualify for the insurance necessary to achieve a cost efficient alternative to options other than Option 1; in which case Options 2, 3, or 4 can be suitable choices. That being said, there is no reasonable excuse for a participant not taking the time to perform their due diligence with regard to one of the most important financial decisions of their life. Regardless of the option eventually chosen by participants, the importance of a participant and their family taking the time to make the most suitable choice for their specific circumstances cannot be stressed enough.