Knowing When a Rollover Is for You

An important decision needs to be made when you leave an employer. It doesn’t matter if your leaving is due to retirement, taking a new job, or a layoff. You have to decide what to do with any retirement accounts at the employer you’re departing. The right answer varies from person to person. In this visit, I give a framework for making the decision that will enhance your financial security.

The decision depends on the type of account involved. A defined contribution account (such as a 401(k) plan) has some different considerations than a defined benefit plan. A defined benefit plan (DB) is the kind that promises you a fixed payment for the rest of your life.

We’ll tackle the DB plans first, and then look at 401(k)-type plans.

About half of DB plans let you choose between an annuity and taking a lump sum. The choice usually is the same whether you leave the employer at retirement age or leave at a younger age.

More than 90% of employees choose the lump sum, according to The Wall Street Journal. I’m sure many people select the lump sum because they want control of the money. Some believe they can invest is to earn a higher return than is reflected in the annuity, and probably a few don’t trust their employers. Others use the lump sum to pay down debt or other expenses or to make a large purchase they’ve been delaying.

Those are important factors to consider. But to maximize wealth, consider how the employer calculates the lump sum amount.

The lump sum is supposed to be the amount you need today to be able to generate a fixed payment equal to that promised by the pension plan. To make the calculation, the pension plan assumes a rate of return that will be earned by the lump sum while you draw it down during retirement. The rate selected determines how much of a lump sum you’ll receive. A higher rate means you’ll receive a lower lump sum, because more of the future payments would be assumed to come from investment returns. A lower rate means you’ll receive a larger lump sum, because investment returns will be lower.

A tax law change that took effect in 2008 and is being phased in changes the amount you’ll receive. Before the change, retirement plans were required to use the treasury bond interest rate. After the change, they’re allowed to use a corporate bond rate. The corporate bond rate is higher, so the amount of the lump sum paid to employees is declines.

The amount by which the lump sum is reduced varies. The younger you are the bigger the difference, because of the effect of compounded returns over time. But at any age, you’ll receive less under the new rule.

Not every pension plan is using the corporate bond rate to calculate lump sums. Plans have discretion to phase it in through 2012, and some are delaying use of the higher rate. Before choosing between a lump sum and annuity, you should ask the plan administrator how the lump sum is calculated.

One easy way to evaluate the lump sum offer is to ask insurance agents how much of a monthly annuity you can purchase with the lump sum and compare that to the annuity you would receive from the plan. You can get a range of quotes from www.ImmediateAnnuities.com. If you can buy a higher-paying annuity from an insurer, you might want to take a lump sum. When a private annuity would be lower than the plan’s annuity, you should wonder how you’ll be able to make the lump sum last.

There are other factors to consider.

The pension annuity might come with other benefits, such as an early retirement payment, disability payout, or other features. Be sure you know all the benefits you’re giving up with a lump sum.

Some departing employees take a lump sum because they fear the employer will go bankrupt. But defined benefit pensions are insured by the Pension Benefit Guaranty Corporation, up to a maximum monthly amount. Unless your monthly pension would exceed the guarantee limit (currently equal to $54,000 annually for a 65-year-old), a potential bankruptcy shouldn’t be a major consideration.

Consider your other financial resources. Some new retirees have other assets and sources of income. Taking the pension as a lump sum allows them to invest it more aggressively for a potentially hire return. This is a good strategy if the other resources provide for a comfortable retirement regardless of how the investments with the lump sum turn out. Or when other resources are adequate, the lump sum can be used to create a bequest or gifts for charity or loved ones.

You also need to consider longevity. When the pension plan calculates your lump sum, it assumes an investment return and life expectancy. But if you outlive that life expectancy, the pension plan still is on the hook to continue the payments. If you take the lump sum and exceed life expectancy, you have to spend less or earn a high enough investment return to cover those extra years.

The pension plan also assumes the risk of investment returns that are lower than the assumption. When you take a lump sum, you assume the risk and consequences of low investment returns.

The considerations for a 401(k) or other defined contribution plan are different. Whether you take the lump sum or stay with the plan, you’re making the investment decisions and taking the risks of a long life and low investment returns.

Many people automatically take a lump sum from their 401(k) plan when leaving an employer, and the financial services industry certainly encourages that action. But that might not be the best move for you. Consider all the factors before deciding.

The 401(k) plans maintained by many small and medium-size employers and even some large employers are inferior to an IRA. They have limited investment options that often aren’t among the best funds available. The costs can be high. There also might be limits on how often changes can be made in the investments and when money can be taken from the plan.

With a 401(k) plan you also need to consider long term. Check to see how the plan treats your account when you turn age 70½ or when a beneficiary inherits the plan. Some plans require fast payouts in these circumstances.

When a plan has these drawbacks, your best action is rolling over the 401(k) plan to an IRA or your new employer’s plan.

But some 401(k) plans, especially those maintained by large employers, are pretty good. The employer is careful to negotiate low expenses in both the investment funds and the other plan costs. The employer often picks up some or all of the plan costs.

In those cases, when all costs are considered a 401(k) can be cheaper than an IRA. Many 401(k) plans have access to “institutional” shares of funds, which charge lower expenses than the shares of the same funds available to most IRA investors.

An employer that takes its 401(k) seriously also seeks out the best funds in each asset category, offers a wide range of asset categories instead of just the basic five or so, and works with outside firms to design target date plans or similar asset allocation funds that are better than the off-the-shelf products at most fund families. You’ll have more investment choices in an IRA, but a well-run 401(k) narrows your choices down to the best ones you’d find yourself and negotiates lower fees.

A 401(k) plan also is likely to have a stable value fund option, which is a good place to hide while earning a decent yield when you want to be out of the markets or are mapping out your future.

A major downside to staying with even a good 401(k) plan is that you can’t consolidate your assets in one account.

Don’t automatically assume that rolling over your 401(k) to an IRA or a new employer’s plan is the best choice. Take a hard look at the current 401(k) plan and decide if its costs, investment choices, and other features are a good deal.

RW September 2011.