What to Consider When Faced With the Pension Election Decision

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1 PENSION ELECTION Key Information About Your Pension (Optional Forms of Benefits) Pension Math and Factors to Consider Pension Maximization What Happens if Your Company Files for Bankruptcy and Your Company Plan Is Taken Over by the Pension Benefit Guaranty Corporation (PBGC) What to Consider When Faced With the Pension Election Decision If you are on the verge of retirement and fortunate enough to have a pension, you may be faced with an important choice. Should you take the regular, lifetime payments that your company plan offers or should you select a lump-sum distribution option and invest the funds on your own, perhaps rolling the proceeds into an Individual Retirement Account (IRA) or investing in an annuity form not offered under your company plan that is more tailored to your needs? Before you make an irrevocable decision about your future, you should take time to understand what options are available to you and what each choice might mean for you and your family. If you are within a few years of retirement, doing groundwork now can help you understand your options and allow you to plan for the retirement income program that you feel is most appropriate for your situation before a decision has to be made. Also, in the event that you are laid off, it s good to have thought through this decision well in advance versus having to make this important decision amid a barrage of choices that must be addressed within a short time. continued

2 PENSION ELECTION Your pension payment is an important part of your overall retirement plan. Be sure to talk with your Company Human Resources (HR) Department (who should have the most information on your company plan), us and your tax advisor about the following topics: Key Information About Your Pension (Optional Forms of Benefits) Pension Math and Factors to Consider Pension Maximization What Happens if Your Company Files for Bankruptcy and Your Company Plan Is Taken Over by the Pension Benefit Guaranty Corporation (PBGC)? Is Your Company Plan Retirement Benefit Fully Covered by the PBGC Guarantees? We address each of these issues in detail on the following pages and suggest that you use the information provided here as a guide for your discussions. Key Information About Your Pension You and your advisors will need, at a minimum, an up-to-date Summary Plan Description (SPD) and the most recent Individual Plan Benefit Statement (from your Company HR Department). Some plan sponsors may send these documents (as well as a copy of the actual Plan document) to the plan participants automatically. Otherwise, to receive a copy, you should ask your HR or Benefits Department for copies. The plan sponsor is required by law to provide you with these documents upon receiving a written request. Your plan documents will spell out when your benefits become available and what your monthly payment options are. For the most part, when you can begin collecting pension benefits is determined by your plan and is described in the Summary Plan Description. Most plans will not allow you to receive your pension until you have separated from service. However, whether you have separated from service or are still working, upon attaining normal retirement age (usually age 65) you are eligible by law to begin receiving benefits. Once you have separated from service, or turn 65 if still working, you will be presented with your options. These may include a lump-sum distribution, an immediate monthly benefit or a deferred monthly benefit that usually starts at age 65 or the normal retirement age as defined by your plan. Once you are eligible to collect, your payment options may include some variation of these options: SINGLE LIFE OPTION Suitability: This choice may be appropriate for retirees who want income for their own needs and who don t have dependents or heirs that, in the owner s judgment, will need or should be included in future cash flow from this asset. This is the usual default option for single retirees offered under many plans; if married, the participant s spouse has to consent to this selection. Benefit: It usually provides for the highest payout, since the payment is calculated based solely on the life of the person collecting the pension benefit (the annuitant ). Risk: Payments end upon death of the annuitant, with nothing remaining for family members. 2 MORGAN STANLEY SMITH BARNEY

3 JOINT AND SURVIVOR (J&S) LIFE OPTION Suitability: This option, which is the default option for married participants, is often selected by retiring employees who are concerned about the financial welfare of their spouse who could become a widow or widower. The monthly payout is calculated on combined life expectancies of the owner and spouse, which may result in a smaller monthly payment versus the Single Life Option. Many plans offer some variation of J&S annuities that provide equal amounts to be paid to the participant, and upon the participant s death, to the participant s spouse (usually referred to as a 100% J&S Annuity ). Some plans provide other options, with higher payouts for the participant, and lower payments for the deceased participant s spouse. The advantage is that the payments are structured to last over the life spans of two people and can be designed to avoid any decline in cash flow following the death of a coannuitant. Benefit: It provides for continued and nonreduced income (if so designed) for the spouse after death of the owner/ coannuitant. Risk: It generates a lower income than the Single Life Option because the calculation is based on life expectancy of both husband and wife. PERIOD CERTAIN Suitability: This alternative is designed for those who want to guarantee a specific payout for themselves and/or their heirs. Benefit: Annuitant can exercise some control to generate a certain income stream over a predefined length of time ( period certain ). Heirs can inherit any balance, so the funds remaining in the annuity aren t forfeited upon death of the annuitant. Risk: The defined period usually ranges from 10 to 20 years, so annuitants who commence receiving payments and then exceed their predetermined range would outlive the cash flow payout. Your HR Department is required to provide you with the projected benefits for each of the options offered under your plan, and we can help you analyze these amounts and assist you in determining which option works best for you given your life circumstances, goals and other assets/income streams. Pension Math and Factors to Consider It s important to understand that all of the payment options are designed to be actuarially equivalent by law, meaning that any one of the choices would net out the same if you and your spouse live for an average length of time. Currently, American women live an average of 81 years and American men live an average 76 years 1. However, longevity tends to run in families. With this in mind, your decision should be based not just on averages but also on other factors specific to your situation. It s important to understand that all of the payment options are designed to be actuarially equivalent by law, meaning that any one of the choices would net out the same if you and your spouse live for an average length of time. 1 Expectation of Life at Birth, and Projections, 2010 Statistical Abstract, U.S. Census Bureau. MORGAN STANLEY SMITH BARNEY 3

4 PENSION ELECTION Considerations that favor monthly payments: You are likely to live past the actuarial average. You would like another source of guaranteed income to meet current and/or anticipated future monthly expenses. You want the convenience and security of a monthly check. You are not certain of your desire or ability to effectively manage a potentially large single sum (also called a lump sum ) payout. Your plan has a cost of living adjustment that increases your monthly pension payments to take inflation into account. Your spouse may not be as capable as you of managing a lump sum. You (and your spouse) have sufficient additional assets saved to address unforeseen economic needs. Considerations that favor a lump-sum payment: You want financial control over the money and have the self-discipline and investment knowledge needed to manage it well. You believe that you can earn a higher rate of return on your lump sum than what is assumed as part of the pension calculation. (Note: You can determine a hurdle rate of return, which is the rate you would need to achieve so as to have been better off taking the lump sum at different assumed life expectancies.) The solvency of your employer or your plan is in question, and the PBGC does not fully guarantee all of your company pension plan benefit (see What Happens if Your Company Files for Bankruptcy? ). You don t need additional monthly income to meet expenses. You don t think your pension plan s cost-of-living increases (if available) will be sufficient to keep up with the growth of your expenses down the road. You want to have more control over how your retirement funds are invested. (For example, you want to invest in green technology or don t want your money placed with certain controversial companies or in particular industries.) You want to leave all or part of this asset to loved ones (in addition to your spouse). This may not be an all or nothing decision, depending on the circumstances. Some other options include the following: If you choose a lump-sum benefit and then use all or a portion of it to buy an annuity, it would also generate regular monthly income. Therefore, the choice of a lump-sum payment does not necessarily mean giving up the advantages of regular monthly payments, and individual annuities may offer other valuable features that are not available under your company plan options. (You should carefully compare, however, the costs and features of an individual annuity versus the cost of the annuity benefits offered under the plan to make an appropriate decision.) Another alternative is to just leave the money in your former company s pension plan to grow at a predetermined rate until you are ready to take it. This option often provides for lower or company-subsidized management fees versus some other choices. However, if your balance is less than $1,000, the company may require you to roll the funds out of their plan. 4 MORGAN STANLEY SMITH BARNEY

5 Pension Maximization As the name suggests, this strategy can help you to get the most out of your pension payment. It takes a bit of calculation and careful planning. Here s how it works: First, you determine the difference between the single life and joint survivor payment monthly payouts. Based on your situation mainly your age, health and lifestyle (e.g., smoking status, gender, exercise level) you determine how much insurance you can purchase with the difference between the higher and lower payouts. Based on the calculation that you just did, determine if you can purchase with that cash difference a sufficient amount of permanent life insurance on yourself to provide a cash flow near the level of income that would be lost to your spouse if you should die and your pension then ceased. In most cases, and assuming that you are insurable, the cash difference you calculated (after any taxes that may be owed on that cash difference once distributed from your retirement plan if used to pay for the life insurance benefit) should be more than enough to purchase the life insurance needed. Secure the life insurance coverage prior to electing your pension payout option and name your spouse as the beneficiary. (Note that term life insurance does not work well for this concept, since it will eventually expire or become prohibitively expensive.) You then select the Single Life regular payment option at retirement receiving the maximum monthly pension payout for benefit of you and your spouse as long as you live. If you predecease your spouse, the life insurance death benefit would then be paid to your spouse, replacing the monthly pension income that you were receiving during your lifetime. This payment can be a tax-free lump sum or structured as a monthly income to your spouse for the remainder of her life. Under pension maximization, if your spouse should predecease you, you d have the option of keeping the insurance and naming a new beneficiary or cancelling the insurance and receiving the accumulated cash value tax-free unless and until the amount of your surrender value exceeds the premiums you ve paid. Some possible benefits of pension maximization include the following: You and your spouse receive the highest cash flow from your pension while you both are living. The life insurance could, in some instances, provide a larger cash flow to your spouse than the former pension payments that were received while you were living. (This would be more likely if the insurance had been purchased several years before your planned retirement.) The life insurance option within the pension maximization strategy may not be subject to claims of creditors against you or your estate. (You should consult with your attorney for proper structuring to preserve all benefits.) Your spouse s death could precede yours in which case, you d have received a reduced monthly income for the rest of your life if you had taken the joint payout option. Under pension maximization, if your spouse should predecease you, you d have the option of keeping the insurance and naming a new beneficiary or cancelling the insurance and receiving the accumulated cash value tax-free unless and until the amount of your surrender value exceeds the premiums you ve paid. MORGAN STANLEY SMITH BARNEY 5

6 PENSION ELECTION Any life insurance proceeds remaining at the death of the surviving spouse/beneficiary could pass to other family members. You could diversify your insurance risk by making sure that the carrier that sells you the insurance policy is different from the insurance company paying your annuity payments under the company plan s policy. Generally, the younger you are when you purchase the life insurance element of this concept the better pension maximization works, since you lock in the premium rate based on your age at time of purchase and because your health would likely be better at a younger age as well, which allows for a better rate. However, this concept may work as well even if purchased at retirement time. We can help you determine if pension maximization works for you. Generally, the younger you are when you purchase the life insurance element of this concept the better pension maximization works, since you lock in the premium rate based on your age at time of purchase and because your health would likely be better at a younger age as well, which allows for a better rate. What Happens If Your Company Files For Bankruptcy? There are two common forms of bankruptcy. In Chapter 11, a company stays in business while it reorganizes its finances. In Chapter 7, a company goes out of business and liquidates all assets. In Chapter 11, pension and health plans are often though not always continued, while these plans are terminated in Chapter 7. In either case, if the plan is a standard defined benefit retirement plan subject to ERISA, the PBGC guarantees basic benefits earned before your plan s termination date (or the date your employer s bankruptcy proceeding began, if applicable). For 2010, the maximum guaranteed amount is $4, per month ($54, per year) for workers who begin receiving payments from PBGC at age 65. The maximum guarantee is lower if you begin receiving payments from PBGC before age 65 or if your pension includes benefits for a survivor or other beneficiary. The maximum guarantee is higher if you are over age 65 when you begin receiving benefits from PBGC. For a more detailed description of benefits and the limits on guarantees, see PBGC s publication, Your Guaranteed Pension. 6 MORGAN STANLEY SMITH BARNEY

7 If the plan is a standard defined benefit retirement plan subject to ERISA, the PBGC guarantees basic benefits earned before your plan s termination date (or the date your employer s bankruptcy proceeding began, if applicable). Connecting All The Pieces You shouldn t make a decision in isolation about how to receive your pension benefits. Preparing for retirement requires a comprehensive planning process. We can work together to estimate the cost of your retirement, analyze your income sources and choose an appropriate investment strategy to meet your goals and family situation. Consumer Tips for Safeguarding Your Pension 2 Know your pension plan. Obtain and review your Summary Plan Description (SPD), the rulebook for your pension. Review your Individual Benefit Statement and individual account information. Know what your accrued and vested benefits are. Maintain a pension file. Keep records of where you ve worked, dates you ve worked there, your salary and any plan documents or benefit statements you ve received. Notify your plan administrator of any changes that may affect your benefit payments (i.e., marriage, divorce, death of a spouse). Know the person in your company who has information about your pension plan and can give you plan documents. Get copies of pension estimates from your HR Department under the various optional forms of retirement benefits (e.g., single life, J&S, Term) offered under your plan. Explore how a merger or acquisition of your company might affect your pension benefit. Know your pension rights. Request information on your pension rights and how to protect your pension. 2 What You Should Know About Your Retirement Plan, 2010 Employee Benefits Security Administration, United States Department Of Labor. MORGAN STANLEY SMITH BARNEY 7

8 Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Smith Barney Financial Advisors do not provide tax or legal advice and are not fiduciaries (under ERISA, the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise agreed to in writing by Morgan Stanley Smith Barney. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are urged to consult their tax or legal advisors before establishing a retirement plan and to understand the tax, ERISA and related consequences of any investments made under such plan Morgan Stanley Smith Barney LLC. Member SIPC. CLF74412 PS /10

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