Help a Reader: Pension Plan Frozen – What To Do with 3 Choices

by Darwin on November 2, 2011

I got a good question from a reader and wanted to share it with you.  Here it is; I’d be interested to hear your thoughts on how he might best handle this and then I’ll weigh in with my thoughts after hearing from some of you finance buffs.  While things like pension rules, a 401k loan and IRA contribution limits may be important, would love to year your thoughts:

 

Hey Darwin,

I’ve been reading your blog now for a few  months.  My employer has decided to freeze and subsequently close out our the fixed pension plan.  They stopped offering it as a benefit to new employees 5 years ago or so, but now  they are a stopping the plan and disbusing each employees/retirees share.  

I’ve been with the company about 8 years, and have had 5% put towards my pension each year.  I don’t know officially yet, but it looks like there may be three different options.  1.  cut a check 2.  Retirement Rollover (401K/open a Roth IRA)  3.  Annuity

At first glance I was thinking certainly a retirement rollover would be the way to go.  However, when I started to think about it.  I could take that cash, and pay down some debt, depending on how  much I was left with after the government coffers got their unfair share.  🙂  Student loans, car, house,all those need to be paid off.

Anyway,  just wondered what your thoughts were and thought this might make an interesting blog post.

{ 6 comments… read them below or add one }

funancials November 2, 2011 at 11:12 pm

Rollover was my first thought as well, but I think you could make an argument for all 3.

Assuming your average reader is relatively responsible, his student/car/mortgage loans should all be below 5% – so the debt is not a huge concern to me. If he beats his meat to Dave Ramsey, this option becomes pretty sexy.

The annuity may have some sort of lifetime income option which could be advantageous.

Since you’re not immediately offering your advice, I’m curious what your thoughts are.

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Roger Wohlner November 2, 2011 at 11:16 pm

Interesting and all to common situation. Assuming the reader is under 59 1/2 taking the distribution is very expensive money and I would urge him to think two or three times before doing this.

An annuity can be a decent option, especially in conjuction with other retirement savings. I would urge the reader to compare the annuity payouts with other options available outside the plan. Depending upon the insurance company used by the sponsor the annuity may or may not be a good deal.

I would generally tend to favor rolling over to an IRA, this provides the most control for the reader.

All of this should be taken as general, many factors would enter into any recommendation that I would make to a client. I suggest that the reader sit down with a financial planner (fee-only of course) in his area. He can check out the NAPFA find an advisor site http://findanadvisor.napfa.org/Home.aspx for a fee-only advisor in his local area (full disclosure I am a NAPFA Registered Advisor).

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MoneyCone November 3, 2011 at 9:53 am

It depends on a number of factors. Secured vs. unsecured loans, the loan percentage vs. what the reader might lose after paying penalties for cashing out the pension, how much has the reader saved towards retirement, emergency funds, savings rate, stability of current job, how easy it is to get another job if laid depending upon the profession…

Those are some of the questions that pop into my mind. List down all possible scenarios and pay close attention to worst case ones and come up with a mathematically accurate figure to determine what’s the best course of action.

I’m glad the reader is thinking outside the box – that’s a good start!

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krantcents November 3, 2011 at 3:06 pm

For me, the choice is only the rollover. The cash option has penalties and taxes. The annuity has higher built in expenses and fees.

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AverageJoeMoney November 3, 2011 at 6:57 pm

I love this question. Thanks for the opportunity to give my two cents.

Let’s do the math. I’m going to make a few assumptions–not because I want to assume anything about the readers’ situation, but because it’ll help your reader do his/her own math, once they swap my assumed variables for their own true numbers. We’ll assume the reader is 30 years old, the pension is $15,000, and the tax bracket (not rate) is 25 percent.

Choice #1: Cut a check. Because this money is at the top end of the reader’s wages, it’s fair to use the tax bracket rather than tax rate to calculate the tax on this money. The reader will pay 25 percent federal tax and a ten percent penalty. Without computing any damage done at the state level, 35 percent of the reader’s money is gone, or roughly $5,250. The reader now has $9,750 or less to apply to debt. If the reader can’t find a loan to pay down the debt at a better rate than 35 percent, it’s time to read your posts on avoiding a bad credit rating.

Choice #2: Rollover. Here we’ll apply the rule of 72 to do quick math. If you take the interest rate the reader thinks he/she’ll receive and divide into 72, it’ll tell you how many years it’ll take the funds to double. If the reader were to average 8 percent, it would then take 9 years for the $15,000 to double. If the person were to wait until after 59 1/2 to withdraw this money from their IRA, the money would double at 39, 48, 57, and again at 66. By age 57 the $15,000 would have grown to $60,000. If they didn’t need it until 66, it would be $120,000.

Option #3: Annuity. This is more complex math AND the reader would have to assume that the entity is still solvent in the future, because pensions are subject to creditor claims in the event of a bankruptcy. In MOST cases, this is the least favorable option. Sorry…option three sucks for so many reasons, but most are more technical than we have room for here.

So, the question to the reader is this: is it better to forfeit $15k for $9,750 or less to pay down debt OR grow it to $60 – $120k? No brainer.

Obviously, these numbers will be different for the reader, but this is the math I’d do to make the decision….which is almost always to roll it over to an IRA.

Thanks again for letting us weigh in on this! Fun as always, dude!

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Darwin November 3, 2011 at 10:09 pm

Wow, great answers guys; thanks for weighing in!
A few factors I’m thinking about. As far as cutting a check and paying off debt, the debt listed seems to be rather low-interest debt (assuming your student loan is federal and not private lender). After the penalty/taxes, etc., probably not worth it. Between annuity and rollover, I’d choose the rollover into a low cost IRA index fund, preferably with Vanguard (no affiliation, they’re just the most ethical and lowest cost option in the industry in my opinion).

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