The Bogleheads' Guide to Retirement Planning (14 page)

The employer’s second choice is a graduated vesting schedule. Graduated vesting is when an employee’s benefits are vested over time, although no more than seven years. If the employer makes this choice, the vesting schedule cannot be worse than the vesting schedule shown in
Table 5.2
.

The most common scenario for receiving benefits under a defined benefit plan is retiring from the employer, although there are also a few other ways to receive benefits before you retire. The benefit from a defined benefit plan is usually offered as an annuity that provides guaranteed income, year after year. There are several types of annuities. If you are married, the plan must offer you a choice of joint and survivor annuity, which provides a surviving spouse no less than 50 percent of the benefit. A joint and survivor annuity pays the benefit year after year until you die. After you die, your surviving spouse also receives a percentage of your pension until he or she dies. A 50 percent joint and survivor annuity pays 50 percent of your pension to your surviving spouse. The plan may also offer a 75 percent or 100 percent joint and survivor annuity, which pays your surviving spouse 75 percent or 100 percent of your pension after you die, although the pension amount you receive while alive under a 75 percent or 100 percent joint and survivor annuity will be lower than what you would receive under a 50 percent joint and survivor annuity. If you are single, the plan typically offers a single life annuity that pays only you over your lifetime.

Some defined benefit retirement plans can include cost-of-living adjustments (COLA). In such cases, the benefit will increase with the cost of living after you start receiving your benefit. The COLA can be automatic, tied to a predefined index such as the Consumer Price Index (CPI), or it can be ad hoc, to be announced at the discretion of the employer or negotiated between the employer and a labor union. If your plan does not have a COLA, your pension benefit will be a fixed amount after you retire. The purchasing power of fixed benefits will be eroded over time by inflation.

Some defined benefit plans also offer retirees a choice of a lump sum payment or an annuity. If you choose a lump sum payment, you can roll the lump sum into an IRA and invest it on your own, potentially generating more retirement income than the annuity pays. However, you also run the risk of investing poorly and not generating as much income or, worse, running out of money. Which would you choose? That is a very complex and difficult question to answer.

To answer the question of whether to take a rollover or annuity payments, start by seeking quotes from insurance companies to determine what the lump sum can buy in the form of an annuity purchased outside of your employer. It makes sense to take the lump sum and purchase an annuity if you can purchase an annuity with a higher payout from an insurance company than you can receive from your retirement plan. Be sure to compare apples to apples, because the features of the annuity affect the annuity payout value. For example, a joint and survivorship annuity is different from a period certain annuity. Joint and survivorship means both you and your spouse receive payments as long as either of you are living. Period certain means the insurance company will guarantee payments for a fixed number of years, whether the recipient is living or not. You may want to use the service of a fee-only adviser to make this decision, as long as the adviser who helps you has no prospect of managing your lump sum. Otherwise, the adviser may be biased toward a lump sum.

What if you quit, die, divorce, or become disabled before you retire? If you quit and you have already met the vesting requirement, you will have a deferred pension from your former employer. You may have to wait until you reach the normal retirement age (typically 65) or until you meet another early retirement milestone defined by the plan before you can collect your pension benefit. It may very well be 10 or 20 years from the time you left your former employer. Don’t forget about your deferred pension!

A benefit may be payable to your surviving spouse if you are married but die before you retire. If you die after retirement eligibility, a plan typically will treat it as if you chose the default joint and survivorship annuity and then died immediately. The plan will then pay the survivorship benefit under the joint and survivorship annuity. If you died before meeting any early or normal retirement eligibility, your surviving spouse may have to wait until you would have met the early or normal retirement eligibility before collecting a survivor pension from your vested benefit. A defined benefit plan typically does not pay any benefit if you die while you are single.

Your pension benefit may become a part of your divorce settlement if you get divorced. The court must issue a qualified domestic relations order (QDRO), which stipulates how your benefits will be divided between you and your ex-spouse. Your pension plan then records the QDRO and follows it accordingly. You will probably have to wait until your ex-spouse is eligible to retire before you are eligible to receive a pension benefit from your ex-spouse’s plan (more on this in Chapter 19).

If you become disabled while working for the employer, assuming you have long-term disability coverage, you will receive income under long-term disability. When you reach the normal retirement age, you then start receiving pension benefits from your defined benefit retirement plan. Some plans will calculate your years of service up to when you became disabled; some plans will credit you years of service as if you continued working at the same rate of pay.

Your pension plays a very important role in your retirement planning, but how can you be sure it will be there when you need it? The employer can discontinue the defined benefit plan at any time. That does not mean you will lose the benefits you have accrued; however, you will stop accruing more benefits.

There are two layers of safety nets for the benefits you already earned. The first is the plan’s assets, which are held in a trust, separate from the company’s other assets. The plan’s trust is a separate legal entity that holds assets for the plan participants. The employer is legally required to maintain the plan’s funding level. If the employer goes out of business, the plan’s assets are still available to provide the benefits the employer had promised.

What if the plan is underfunded when the employer terminates the plan or goes out of business? The second layer of safety net is a government agency called the Pension Benefit Guaranty Corporation (PBGC). PBGC collects insurance premiums for all defined benefit plans in the private sector. If a plan is terminated, PBGC takes over the liability of paying the plan benefits. However, this guarantee has a limit. The limit depends on when the plan is taken over by PBGC, your age, and whether the benefit is a straight-life annuity for a single person or a 50 percent joint and survivor annuity for a married couple. PBGC publishes the limits every year. For example, for plans terminated in 2009, the PBGC maximum guarantee for a 65-year-old is $4,500 a month for a straight-life annuity or $4,050 a month for a joint and survivor annuity, assuming the spouse is also 65 years old. The maximum guaranteed amounts for a 60-year-old are $2,925 and $2,632.50, respectively.

The maximum guaranteed amounts may be much less than what the participants had anticipated from their pension plan for participants with higher accrued benefits. If you are counting on your pension in your retirement planning, you must also take into consideration the possibility of the plan being discontinued by your employer or taken over by PBGC. The current PBGC maximum monthly guarantees can be found on PBGC’s web site at
www.pbgc.gov
.

Defined benefit plans in the private sector have been in decline in the last 30 years. The number of private-sector defined benefit plans dropped by almost two-thirds, from 148,000 in 1980 to 47,000 in 2004, according to the Employee Benefit Research Institute.

Few defined benefit plans are being created, and many more are being closed. Some employers with an existing plan are not offering it to new employees, while previously hired employees continue accruing benefits. Some employers froze their plan and do not allow existing employees to accrue more benefits. Some terminated their plan altogether. Some converted their plan to a cash balance plan. The motive behind these moves is usually cost savings.

A defined benefit plan is very expensive for the employer. If the plan’s investments do not perform well, the employer has to make up the shortfall with additional contributions to the plan. That typically occurs at the same time the economy turns down and the employer’s own business is not doing well. Often, retiree longevity assumptions are wrong, and they live longer. That creates a shortfall for future retirees. The pension plan must keep paying the monthly pensions for longer periods of time than the plan’s actuary originally projected. Count yourself lucky if you still have a defined benefit plan, but also keep in mind that it may go away in the future.

The trend for public-sector defined benefit plans is different than the decline in private-sector plans. Most public-sector employers still offer a defined benefit plan. However, a new trend is developing in the public sector to offer defined contribution plans in addition to, not in lieu of, defined benefit plans. That reduces the cost to the employer in the long term.

A key difference between public-sector defined benefit plans and private-sector defined benefit plans is that the public-sector plans are not covered by most provisions of ERISA. Public-sector employers do not pay taxes, so the federal government cannot induce them to design plans in a certain way in order to qualify for favorable tax treatment. Public-sector employers have more freedom in designing their plans, and there are large variations among public-sector plans. Many public-sector plans are created by legislation or ordinance. Changes to those plans are done through the legislative process.

Public-sector defined benefit plans are not insured by PBGC, the agency that insures private-sector defined benefit plans. Many think the public-sector plans are still safe because public-sector employers have taxing authority and the benefits are guaranteed by state or local laws and ordinances. However, that may not be true if the plans are underfunded. A recent study by two researchers at the National Bureau of Economic Research conservatively predicted that among all state pension plans, there is a 50 percent chance of aggregate underfunding greater than $750 billion and a 25 percent chance of at least $1.75 trillion. When public-sector employers cannot adequately fund the pension plans, they will need to increase taxes, require additional contributions from employees, cut benefits, or institute a combination of several solutions.

The civilian employees of the federal government are primarily covered under two defined benefit plans. The Civil Service Retirement System (CSRS) covers employees hired through 1983, and the Federal Employees Retirement System (FERS) covers employees hired after 1983. CSRS participants are not covered by Social Security, whereas FERS participants are covered by Social Security. As a result, the benefits under CSRS are higher than those under FERS. Both CSRS and FERS provide postretirement cost-of-living adjustments, disability pensions, and survivorship benefits.

The retirement benefit under CSRS follows the basic formula:

Pay in this equation is defined as the high-three average salary, which is the highest average basic pay earned during any three consecutive years of service. The benefit percentage is 1.5 percent for the first 5 years of service, 1.75 percent for the next 5 years of service, and 2.0 percent for years of service over 10. The normal retirement age under CSRS is 62 with 5 years of service, 60 with 20 years of service, or 55 with 30 years of service. There are special provisions for specialty occupations (air traffic controllers, law enforcement, and firefighters) and for employees who terminated employment because of major reorganizations. More information on CSRS can be found at the U.S. Office of Personnel Management’s web site,
www.opm.gov.
.

Participants are not covered by Social Security. However, if they become eligible for Social Security based on their spouse’s work, their Social Security benefits may be reduced by up to two-thirds of their CSRS benefits. This is called government pension offset (GPO). You can find more information about GPO from Social Security Administration Publication 05-10007, available online at
www.ssa.gov
.

If CSRS participants become eligible for Social Security based on their work outside their federal government job, their Social Security benefits can also be reduced according to a complex table published by the Social Security Administration. This is called the windfall elimination provision (WEP). You can find more information about WEP from Social Security Administration Publication 05-10045, available online at
www.ssa.gov
.

The retirement benefit under FERS follows the same basic formula:

Pay is also defined as the high-three average salary in the FERS formula. The benefit percentage is straight 1.0 percent unless you retire after age 62 with 20 or more years of service, in which case the benefit percentage becomes 1.1 percent. The normal retirement age is 62 with 5 years of service, age 60 with 20 years of service, or age 55-57 (depending on your year of birth) with 30 years of service. There are also special provisions for air traffic controllers, law enforcement, and firefighters. FERS participants who retire before they are eligible for Social Security may also receive a supplemental benefit until they become eligible. The U.S. Office of Personnel Management’s web site about FERS is at
www.opm.gov.
.