A recent rule change has resulted in the Pension Benefit Guarantee Corporation(PBGC) guaranteeing 401(k) balances that are rolled into eligible pension plans. What this means is that if a company offers a pension plan 401(k) balances can be rolled over into the pension and the pension benefit that would result from the rolled over balance will be guaranteed by the PBGC just like the original pension benefit prior to the rollover.
This will only impact folks whose employer offers both types of plans. What are the pros and cons of doing this type of rollover?
One of the complaints about the current system of defined contribution planssuch as a 401(k) is that it places the responsibility for retirement saving on employees unlike defined benefit plans. (For more, see: A Primer on Defined-Benefit Pension Plans).
Many experts in retirement income feel that participants will mostly be better off with a guaranteed stream of lifetime income of the sort provided by taking a pension benefit as an annuitized stream of income. This takes the onus off of participants to manage their own retirement assets.
NO INFLATION PROTECTION
The rule change pertains to corporate pension plans rather than municipal, state and federal governmental plans. Corporate pensions are rarely indexed to inflation via cost of living adjustment (COLA) as are public sector pension plans. Once payments have commenced retirees are subject to the impact of inflation on the purchasing power of their monthly payments. (For more, see: Tips for Managing Inflation in Retirement).
If the balance had been left in the employee’s 401(k) plan account they might have had the opportunity to earn investment returns that would keep them ahead of inflation. On the other hand their account could lose money in a down market.
Moreover the combination of having a defined benefit plan as well as a 401(k) plan or similar defined contribution plan is a powerful one. This provides a means for retirement savers to diversify their sources of retirement income. They can annuitize their monthly pension benefit providing a stream of guaranteed (or mostly guaranteed) income along with the opportunities for investment growth that comes with a defined contribution plan.
Many corporate pension plans are freezing their benefits. When this happens workers can no longer accrue additional pension benefits based upon the pension formula such as one based on earnings and years of service. (For more, see: Can You Count on Your Pension?).
The implications for anyone contemplating rolling all or part of their 401(k) is the risk of turning these dollars into “dead money.” This means that a participant may have anticipated receiving a pension benefit from 401(k) dollars that was commensurate with the pension formula based on years of service and earnings. Instead the former 401(k) money is now stuck in a pension plan with a stagnant benefit.
If this money had been left in the 401(k) plan at least there would have been the opportunity for future investment gains.
PBGC BENEFIT LIMITS
Currently the PBGC guarantees pension payments up to $60,165 annually. A visit to PBGC’s web site provides a range of benefit maximum guarantees which will vary based on a number of factors including an employee’s age on the date the company defaulted on their pension obligations. Remember, the PBGC is only a factor if the employer offering the pension goes bankrupt, otherwise pension payments are a liability of the corporation just like a bank loan. (For more, see: The Investing Risk of Underfunded Pension Plans).
A nice feature of the new rules is that any money rolled over to the pension plan from a 401(k) is not subject to this $60,165 annual limit. If a pension plan were to come under the PBGC guarantee the employee would receive a monthly annuity payment based on the amount of 401(k) money transferred to the pension plan in addition to the payment for the original pension plan benefit.
WILL THIS CATCH ON?
CNBC conducted an online reader survey and a resounding 92% of respondents indicated that they would not consider rolling their 401(k) money into their employer’s pension plan. (For more, see: Should You Roll Over Your 401(k)?).
This is not all that surprising considering how popular lump-sum distribution options from pension plans have been traditionally. Many retirees seem to prefer having more control over their retirement nest egg via a rollover into an individual retirement account (IRA) account. This arrangement offers flexibility in the amount withdrawn and allows options in terms of leaving the money to heirs, via an inherited IRA for example.
Another factor might be that the PBGC is not nearly as well known as the Federal Deposit Insurance Corporation (FDIC) which performs a similar function by insuring bank deposits.
SHOULD YOU ROLL YOUR 401(K) TO YOUR PENSION?
As with most financial planning issues the answer is that it depends. Everyone’s personal circumstances are different but here are a few factors for financial advisors to consider for clients.
Are they comfortable managing their 401(k) and any subsequent rollover to an IRA? This is always a consideration if they are faced with an option to take a payout as an annuity or rolling over a lump sum.
What other retirement resources do they have? Do they already have significant retirement investments outside of their current employer’s plan? This might include an IRA, taxable investments or an annuity. Additionally don’t forget to take their spouse’s retirement plan assets into account. Social Security and pensions from former employers should also be considered. In short you will want to look at a client’s entire retirement picture before making the choice as to whether they should move current 401(k) assets to a pension plan. (For more, see: Maximize Your Social Security Benefits).
THE BOTTOM LINE
It’s difficult to say whether the new rule allowing employees to roll their 401(k) balances into their company pension plan will catch on. While it is well intentioned there are a number of pros and cons to consider. Everyone’s situation is different so a careful analysis is required.