The Bogleheads' Guide to Retirement Planning (13 page)

People are always looking for a legal tax shelter, and many people are missing out on one of the best by not contributing to an IRA. To truly minimize your taxes and maximize your newfound tax shelter, make sure you are choosing the right IRA for your needs. If you have low income, take advantage of the retirement savings credit to further increase your savings. You might even be eligible for an extra $1,000 return on your first $2,000 of retirement savings if your income is less than $30,000 per year!

Employer-sponsored retirement plans are divided into two types: defined benefit plans and defined contribution plans. Defined benefit (DB) plans provide a promised monthly benefit to employees at retirement. Defined contribution (DC) plans do not promise a specific benefit at retirement. Instead, contributions are made to individual accounts for the employees. An employee’s benefit at retirement depends on the amount of those contributions and the investment gains and losses on the contributions.

The focus of this chapter is on defined benefit plans. Less than 40 percent of Americans in the private sector are covered. That is a stark decline from the 60 percent coverage 25 years ago. Nonetheless, DB plans still serve a very important role for the retirement security of millions of people. This chapter will show you what these DB plans are, how the benefits are determined, and how you should incorporate them into your retirement planning.

A DB plan is commonly referred to as a pension plan. A DB plan is a program sponsored by an employer to provide income to employees when they retire. The income benefit is calculated according to a specific formula. The inputs to the formula typically include a salary history, years of service with the employer, age, and when benefits begin.

Here is an example: Acme Corporation’s defined benefit plan provides 1.5 percent of the final salary for each year of service at age 65. Susan earned $50,000 a year before she retires at 65. She has worked for Acme for 40 years. Susan’s retirement benefit is determined by a formula. After she retires, Susan will receive an annual pension of $30,000 from Acme’s defined benefit plan ($50,000 × 1.5 percent × 40).

Defined contribution plans are discussed in detail in Chapter 6. For the sake of clarity in this chapter, a defined benefit plan is different from a defined contribution in that the DB plan life-long income benefit is a function of a formula, whereas the DC benefit is simply the total value of an employee’s account at retirement, whatever that value happens to be. DC plans also typically pay a lump sum at retirement rather than an income benefit.

According to the Employee Benefit Research Institute, as of 2005, 37 percent of private-sector employees were covered by a DB plan. That number is down from 84 percent in 1979, but it still translates to more than 20 million active workers in the private sector. Typically, employers who sponsor a defined benefit plan are larger, more established companies in traditional industries.

If you are represented by a labor union or are employed in the public sector, you are more likely to be covered by a DB plan. The public sector includes federal and state governments, police, fire, and the military, public education, and county and local governments. If you work in a nonunion private-sector position, chances are you are not covered by a DB plan. Ask your employer’s human resources department if you are not sure.

Private sector defined benefit plans must comply with the Employee Retirement Income Security Act of 1974 (ERISA) to qualify for favorable tax treatments. ERISA is a federal law that sets minimum standards for most voluntarily established pension and health plans in private industry to provide protection for individuals in these plans.

The law requires plans to provide participants with plan information including important information about plan features and funding, provides fiduciary responsibilities for those who manage and control plan assets, requires plans to establish a grievance and appeals process for participants to get benefits from their plans, and gives participants the right to sue for benefits and breaches of fiduciary duty.

The ground rules for all plans are set by ERISA, and those that comply are called qualified plans. The similarities between plans are due to ERISA requirements. While the outline of the plans can be similar, every plan is different because employers are given some freedom in how they can design their plan.

Most defined benefit plans give pension benefits based on your years of service. The longer you work for the employer, the higher your pension benefit. For each year of service, you earn a pension credit. The credit can be a fixed dollar amount or a percentage of your pay. For example, if a plan using the fixed dollar formula pays $500 per year of service, an employee with 40 years of service will receive $20,000 a year after retirement. Most plans, however, don’t use the fixed dollar formula. They tie the pension benefit to your pay. The basic formula for most defined benefit plans is:

Every component in the basic formula is rigorously defined in the plan rules. The pay in the formula can be defined in many different ways. It can mean your pay in the last year before you retire, the average pay of your final
X
years, the average pay over your entire tenure with the employer with or without adjustment for inflation, or the average of your highest pay in
X
years, typically three to five years.

The benefit percentage in the formula does not have to be flat. An employer can reward long-tenured employees with a graded benefit percentage: the more years of service, the higher the benefit percentage. Some plans are integrated with Social Security. For compensation over the Social Security wage base, where the Social Security tax stops, the benefit percentage can be higher. This is called permitted disparity. The current and historical numbers for the Social Security wage base can be found on the Social Security Administration’s web site at
www.ssa.gov
.

The retirement benefit calculated by the formula is usually payable at a
normal retirement age,
which is typically age 65. If you retire early, you may have to wait until age 65 to collect your full pension, or you may choose to receive a reduced pension because you are collecting the benefits for more years. Some plans encourage early retirement by giving the full pension before age 65, if the employee meets a minimum years of service requirement.

The early retirement benefit can be integrated with Social Security, too. Some plans provide a supplement before age 62, when the retiree becomes eligible for Social Security. The idea is that with the supplement, retirees can receive a relatively stable income before and after they are eligible for Social Security.

Because of the way benefits accrue under the basic defined benefit formula, a defined benefit plan gives much higher benefits to long-tenured employees. An employee who works for several employers during his or her career, even if all the employers have identical defined benefit plans, would receive much less in benefits under all employers than what he or she would receive working for a single employer.

Finally, there is a completely different breed of defined benefit plans called cash balance plans. A cash balance plan is a defined benefit plan, but it goes by a formula that’s similar to a defined contribution plan like a 401 (k) or 403 (b) plan. For each year the employee works for the employer, the employer promises the employee a certain amount, typically a percentage of pay, as a cash balance credit. The employer then credits interest to the cash balance at a predefined rate, for example, 5 percent or the 10-year Treasury yield. The retirement benefit is expressed as the sum of the cash balance credits over the years, plus accumulated interest. The formula is:

The promised cash balance and interest credits do not necessarily equal the assets held by the plan, so a cash balance plan falls under the defined benefit plan category.

A defined benefit plan in the private sector is typically funded entirely by the employer. The money in a defined benefit plan is placed in a trust account. The plan’s assets are for the exclusive benefits of the plan participants. The trust is separate from the employer’s other assets and is not subject to claims by the employer’s creditors. If the employer runs into financial difficulties, it cannot take money from the pension plan assets. The plan’s trustees and administrator are held to fiduciary responsibilities for the employees and retirees. They are responsible for managing the plan and investing the money.

Each year an actuary calculates the plan’s projected liability and compares that with the plan’s assets and their projected growth. That calculation determines the funding level of the plan. There are legal limits to the minimum required funding and the maximum allowed funding. The employer then contributes to the plan within the range between the minimum and the maximum.

The employer typically hires outside investment management companies to invest the plan’s assets. Some plans’ investments are managed in-house. The assets can be invested in almost anything, including stocks, bonds, real estate, and commodities. Unlike a 401(k) or 403(b) plan, employees and retirees do not control how the money in a defined benefit plan is invested because regardless of how the investments in the plan perform, the employer maintains the same promise to the employees. The employees’ retirement benefit accrual does not depend on how well the investments do. If the plan invested poorly, the employer will have to come up with extra cash to meet the plan’s minimum funding level. If the plan’s investments do really well, then the employer does not have to contribute as much.

In addition to taking the investment risk, the employer with a defined benefit plan (except a cash balance plan) also takes the longevity risk. Because the promised retirement benefit is expressed as a sum of money paid out every year as long as the retiree lives, the pension plan has to keep paying. The retiree receives a lifetime income that never runs out. It is much more secure and easy to plan when you know you have a guaranteed income stream after you retire.

Vesting refers to having a nonforfeitable right of receiving benefits from the plan. A defined benefit plan can require a minimum number of years of service before an employee is eligible to receive any benefit under the plan. If you leave the employer before you are vested, you will not receive any benefit from the defined benefit plan. ERISA imposes maximum vesting periods.

A plan qualified under ERISA has two choices for its vesting schedule. Under the first choice, the vesting schedule cannot be worse than a five-year cliff vesting schedule, shown in
Table 5.1
. Under this option, an employee is not eligible for any benefits before working a certain number of years in service (no more than five). Once you are vested in the plan, your accrued benefits under the plan cannot be taken back by the employer if you terminate.