Over the past decade there has been a growing trend for companies to terminate defined benefit pension plans in favor of defined contribution retirement plans. One Alabama company, Energen, terminated its pension plan this year. Recently, employees of Energen received notice of their options regarding the terminated plan.
With a defined benefit pension plan, a company promises to pay the employee, at retirement, an income for life. How much depends on a number of factors including years of service, income, and age of retirement. In order to fund the pension plan, the company must make ‘pooled’ annual contributions based on a number of assumptions including earnings on investments and average life expectancy of retirees. Contrast this with a defined contribution retirement plan. Under these plans, the employee is allowed to make pre-tax contributions within certain limits which the company often provides some ‘matching’ contributions in order to encourage participation. In other cases, the company may commit to a ‘base’ contribution, say 3% of pay, for all eligible employees while allowing employees to voluntarily make pre-tax contributions in the form of payroll deductions. One of my partners, Hugh Smith, CPA, summed it up by saying, “In defined benefit plans the employer bears the investment risk. In defined contribution plans the employee bears the investment risk. Employers are shifting the investment risk to the employees.”
Why are so many companies terminating pension plans?
The simple answer is money. In the old days, pensions were used as a way to create employee loyalty and to reward long-term employees. Two big things changed. First, improvements in healthcare resulted in people living much longer than the actuaries originally guessed causing the lifetime income payments required by companies to far exceed their expectations. Second, investment returns have also been much lower than expected, particularly since the Great Recession of 2008. This one-two punch resulted in significant underfunding of pension plans across the country. Law requires underfunded plans be made whole which has put a strain on these companies finances. In mass, companies have decided to terminate these plans in favor of defined contribution plans such as the popular 401k plan.
If your company terminates your pension plan, you’ll typically have a number of options.
- Rollover to an IRA. You can roll your account balance over to an IRA and postpone taxation until you begin withdrawing money at retirement.
- Keep your pension plan. You can choose to keep your pension plan based on the ‘frozen’ amount. There’ll be no further company contributions. At retirement, you can typically choose between a number of lifetime income options including lifetime income for just you or a smaller lifetime income for you and your spouse.
- Cash out. You can cash out your pension balance and pay the income taxes now. Certified Financial Planner, Foster Hyde, added this note of caution, “If you’re under age 59½ you may owe a 10% federal penalty in addition to ordinary income taxes.”
What’s your best option?
The definitive answer regarding your best choice is, “It depends!” For example, if you’re in a relatively low income tax bracket, have a small balance and need the money to pay off debt, cashing in may be perfectly fine. Deciding whether to do a rollover versus keeping the pension can require some complex calculations. In a recent case, we determined the client’s best choice was to keep the pension. We calculated that the pension returns were relatively high and this couple had no children so they were not concerned about leaving an inheritance. In many cases, doing a rollover to an IRA is the best choice since you obviously have a lot of investment options, fully control the money, and what’s left over can go to heirs.
My main point is that these decisions should be well thought out and, if in doubt as to your best choice, you should seek the help of a financial professional since these decisions typically cannot be ‘undone’.