You should think of Defined Benefit Plans as “Back end weighted”, because a very large portion of the benefit is accumulated in the last few years of your career. An early retirement, whether voluntary, forced, or in the event of a plan termination can be a disaster. Here’s why.
A quick review of the Defined Benefit Math is in order. Your retirement benefit is the product of years of service, times a percentage of earnings for each year, times a final average earnings amount. That amount is payable at your normal retirement, and may be reduced by an amount equal to your Social Security benefit.
Any kind of early retirement changes several of the inputs to the formula. The retiree takes it on the chin three times at once: Fewer years of service, lower final earnings, and an actuarial reduction.
Normal Retirement Calculation
As an example, here is a typical formula:
- For each year of service up to 30 years the worker accrues 1.5% of his final average earnings payable at age 65.
- For each year above 30 years, the worker accrues 2%.
- Final average earnings are defined as the highest five years of his compensation during the last 10 years of service.
- The formula is reduced by $750 per month to account for the employer’s contribution to Social Security.
So, Mary joins XYZ Widget Company at age 25 as a management trainee. She’s fresh out of graduate school and expects to work her entire career at XYZ Widget. She’s ambitious and anticipates working her way up through the ranks to at least senior vice president level. At normal retirement, she’ll have 40 years of service and anticipates that with steady career growth her final average earnings will be $200,000.
Mary does her retirement planning calculations like this:
- Service to 30 years times 1.5% = 45%
- Additional service over 30 years of 10 years times 2% = 20%
- Final average earnings = $200,000
- So, 65% of $200,000 = $130,000
- Social Security Offset of $750 per month = $8000 per year
- Retirement income ($130,000 – $8000) = $122,000.
Termination of employment, Plan Termination, or Distress Termination
Unfortunately, XYZ Widget comes upon hard times and must reduce their executive ranks. Mary gets the axe at age 55!
It’s worth noting that the math works out the same if Mary stays at the company but XYZ Widget terminates the plan, or if XYZ Widget goes out of business and the US Government has to provide guaranteed benefits through the Pension Benefit Guarantee Board (PBGC), the math is the same.
How has Mary’s calculation changed?
When Mary recalculates her benefit it looks like this:
- Service for 30 years times 1.5% = 45%
- No bonus service years
- Mary hasn’t yet cracked the senior management ranks, so her final average earnings are only $120,000.
- Multiplying 45% times $120,000 = $54,000
- Reducing that amount by $8,000 leaves benefit payable at age 65 of $46,000
Because Mary’s career at XYZ Widget was cut short prematurely, she has fewer years of service and lower final average earnings than she might have expected. The Social Security offset is a larger percentage of her benefit because the Social Security offset is a fixed amount, but the benefit amount has fallen.
If Mary finds alternative employment and waits until age 65 to begin her benefit, she will get the entire $46,000, but that’s $76,000 less than she had planned on. Mary would like to make up that deficit, but if she plans on a 4% withdrawal rate, she will need to save $1,900,000 in the next ten years to generate the $76,000 shortfall comfortably.
If Mary earns a net 8% return on her savings during the next ten years, she will have to contribute $131,156 each year to meet her goal. That’s going to be difficult for a middle manager, to say the least. As a practical matter, employees in Mary’s situation can never replace their anticipated benefit.
If Mary is feeling a little burned out, and considers early retirement, or if she can’t find another suitable job, the situation looks even bleaker. She finds that there is a 4% actuarial reduction for each of the 10 years before normal retirement date. So, her benefit would be reduced by another 40%. Mary’s net retirement income from XYZ Widget falls to $27,600 at age 55. And she doesn’t qualify for full Social Security benefits until age 67.
Highly compensated individuals are at particular risk in a Defined Benefit Distress Termination because the maximum benefit that the PBGC will insure is $54,000 a year payable at age 65. In Mary’s case that’s not a factor, but for many senior executives it can be a real blow.
Defined Benefit plans only work well for employees that spend an entire career at a single employer that never terminates the plan. As Mary’s case illustrates, any kind of interruption to the plan falls especially hard on employees in the final stages of their career because of the cumulative effects of formula reductions.
Across America, the Defined Benefit Plan is fast disappearing. To reduce their costs, and eliminate the problems associated with plan underfunding, companies often terminate Defined Benefit plans and replace them with 401(k) plans. As we see in Mary’s case, a 401(k) plan fall far short of replacing her anticipated lost benefits at that stage of her career. Employees covered under Defined Benefit plans must at least consider that their “guaranteed” retirement benefits may not materialize. They should plan accordingly.