Who has a defined-benefit plan anymore? You might be surprised — and if you’re one of the lucky few, there are ways to increase that benefit before you retire.
While such plans, especially traditional final-average salary plans, haven’t been in favor for a long time, 20% of workers in the private sector who have a retirement plan, and a much larger percentage of workers in the public sector, still have these plans.
This represents millions of people who need advice about the trillions of dollars they’re owed in retirement. And for each of these people, small details can make a big difference in their financial security.
Let’s start by looking at the traditional final-average pay defined-benefit plan and then we’ll look at the hybrid cash-balance defined-benefit plan.
Choosing a date to retire
Timing matters. It will be important to check the terms of the plan before picking the day of the year that you will retire. For example, the traditional final pay defined-benefit plan usually uses your “years of service” to determine your benefit. And years of service may require that you worked, for example, 1,000 hours (sometimes 2,000 hours for a full year of service and 1,000 hours for a half year of service).
Example: Mackenzie is in a plan that provides an annual benefit of 2% for each year of service multiplied by her final average salary of $100,000. She has been with her employer for 25 and one-half years. If she retires before the year of service is earned with only 25 years of service, she will get an annual benefit of $50,000 a year (.02 x 25 x $100,000). If she retires after the year of service is earned with 26 years of service, she will get a benefit of $52,000 a year (.02 x 26 x $100,000). She should also inquire with her human resources officer if the plan requires her to be employed on the last day of the plan year to get a year of service. In some cases delaying the retirement date a month, week, or even a day may mean the difference of thousands of dollars over the course of her retirement. In Mackenzie’s case retiring one day later may mean an additional $50,000 ($2,000 a year) over her 25 year retirement.
Choosing a year to retire
As we have seen, the general rule is that working an additional year increases the benefit received. Working longer not only increases the years of service component of the final-average-pay-defined-benefit formula, but it also may increase the final salary on which the benefit is based. In addition, working past the plan’s normal retirement date may also mean that an increase is going to be provided in monthly benefits.
Example: Vincent works in a defined-benefit plan that will pay him $3,000 a month at full retirement age based on a formula of a 1.5 % accrual rate for his 24 years of service and $100,000 of salary (.015 x 24 x $100,000 = $36,000 annually, paid as an annuity of $3,000 a month). If Vincent works three years beyond full retirement age, he will get an annual benefit of $40,500 benefit (1.5 x 27 years of service $100,000). That is $3,375 a month (a $375 a month increase!). But that’s not all. Vincent’s final average salary may have increased to $103,000 based on salary increases in the last three years of work, so his annual benefit would be $41,715 ($3,476.25 monthly) (1.5% x 27 years of service x $103,000 in final average salary). And it gets even better. Since Vincent has worked three years past the plan’s normal retirement date he may get an increased benefit based on actuarial assumptions that account for the fact that he may be getting three less years of payouts from the plan (some plans provide this and some don’t). This benefit may drive his benefit up depending on the assumption used by as much as 24 % from $3,476.25 to $4,310.55 ($3,476.25 x 1.24). In the best case scenario painted for Vincent, his benefit increased from $3,000 monthly to over $4,300 monthly by working only three extra years.
Vincent needs to beware, however. The benefits of working longer in a defined-benefit plan may be hindered by a cap on the years of service that can be used to calculate his benefit. For example, if Vincent’s plan provides a cap of 25 years of service, this would negate two of Vincent’s extra years (but not negate his increased final salary and his actuarial increase). Vincent should also be aware that retirement before the plan’s full retirement age will probably mean an actuarial reduction in his benefit (since his annuity will be paying out for a longer periods).
Planning for the level and types of benefits
If a defined-benefit plan’s definition of salary is liberal (e.g., it includes overtime, bonuses, etc.) then a person may be able to maximize their benefit by working overtime or otherwise finding a way to juice up their salary at the end of their career. If this is a possibility, it is highly recommended.
Example: Maggie has the opportunity to pick up extra shifts the last three years of her career. Instead of having a final average salary of $100,000 she has a final average salary of $110,000 because of the extra work. If the plan has a 2% accrual rate and Maggie worked 25 years, she would receive a monthly benefit of $4,583.33 instead of $4,166.66 a month (a $416.66 increase) (.02 x 25 x $100,000 = $50,000 ($4,166.66 a month) as opposed to .02 x 25 x $110,000 = $55,000 ($4,583.33 a month)).
Up until now we have focused on taking an annuity payout from the plan. Most plans also allow a lump sum payout. What if Maggie wanted a lump-sum payout instead? After all, the vast majority of defined-benefit plan participants who had an option to choose between an annuity and a lump sum distribution chose to take a lump sum distribution. If this is the case, the plan’s actuary will convert the annuity payments due to a lump sum amount. Maggie needs to be aware that her lump sum conversion will be contingent on the prevailing interest rates available at the time. An important consideration is that lower interest rates mean higher lump-sum benefits and consequently higher interest rates mean lower lump sum benefits. In August of 2014 the rate used by the actuary will typically be 1.25 % (as compared with 1.75 % in August 2013). If Maggie anticipates a large change in interest rates, she may want to consider retiring sooner rather than later when interest rates have jumped.
For those of you, like Maggie, who favor some annuitization balanced with liquid funds rolled into an IRA, you will be happy to know that recent changes to the law have made it possible to split your defined benefit between lump sum and annuity payments. Check to see what your plan’s rules are on the matter.
Some people choose to retire early because they will get, for example, a 40% benefit from their defined-benefit plan and they feel they are only working for 60 cents on a dollar. In some cases they can go elsewhere to increase their annual income:
Example: Alex can retire at 55 with a $40,000 pension (40 % of his $100,000 salary and no actuarial reduction will apply). If he goes to work for another company at the same salary, his annual income would increase to $140,000 ($100,000 salary from the new company, plus $40,000 from his former employer’s pension). In addition, his new job might have a second defined-benefit plan or a 401(k) plan with matching contributions that will add to his overall compensation. (The strategy of getting two defined benefits from two different employers is known as double dipping.)
A careful analysis must be made to make sure that a change is the right move. First and foremost job satisfaction and security must be considered. Then there is an economic analysis to be done. How much is he forfeiting in monthly retirement benefits by leaving early? Alex should consider that the final years in a defined-benefit plan can lead to some large pension gains based on increased final salary and increased years of service. Also he should consider the fact that some employees may “subsidize” early retirement benefits (reduce the benefit for a longer payment period, but the reduction isn’t equivalent to a full actuarial reduction, for example the employer may decrease the amount of the payout that starts early, but not to the full affect required by the actuarial tables). Also, early retirement/double dipping may not be possible if Alex hasn’t met the age and service requirement of the current defined-benefit plan. It is strongly recommended that a financial planner be brought in to help analyze the myriad factors that apply in this complicated decision.
Retiring from a cash-balance plan
Many employers have amended traditional final pay defined-benefit plans into hybrid defined-benefit cash balance plans. From the participant’s perspective the cash balance plan is much more like retiring from a defined-contribution plan (e.g., a profit-sharing plan or a 401(k) plan). Unlike a 401(k) plan, however, the participant’s benefit grows with an annual contribution credit, which is tied to the current annual compensation, and interest credits provided by the employer. Technically there is no individual account balance … but for all intents and purposes, that’s what it looks like to the employee. So the amount in your “account” is what you have for retirement.
Unlike in a traditional final pay defined-benefit plan there is not a lot you can do to influence your final annuity benefit or lump-sum payment. An additional year of work means a larger benefit. However, the benefit is based on current compensation for this year and prior years and not on final average salary. For this reason manipulating the final salary and years of service has less of an impact on the overall benefit.