The COVID-19 crisis has complicated the employment situation for many Americans. Many companies are trimming their workforce, and some will offer early retirement packages or normal retirement to eligible retirees as part of their efforts.To help illustrate the considerations involved in the decision between working and retiring, we’ll look at a ‘paycheck to pension check’ comparison for a Defined Benefit (DB) plan. We’ll examine the particulars associated with Defined Contribution Plans in another piece.
Retire now? To many in the throes of the economic fallout, retirement is a distant and unfocused possibility. Getting back to work is the primary objective. There are significant differences between paychecks and pension checks, and the ‘work or retire’ decision should be based on a bottom-line comparison. First, let define what a DB plan is. A DB plan provides a fixed (or defined) benefit to the retiree. This is typically based on a formula of compensation times years of service times a multiplier. So, a typical DB might pay a retiree 2.2% of 5-year final average compensation times years of service. In that case, a 65-year old with 30 years of service with a final average compensation of $60,000 with a 2.2% multiplier (like a State of Ohio employee) would get $39,600 of pension. Most DB plans will have some form of reduction for retiring before a certain age, like 62 or 65. Other plans have supplements for early retirement, like the ’30 and out’ supplement at the Big 3 (in Michigan, the Detroit area is home to three major American Auto Manufacturers, we call them the ‘Big 3’). At first blush, $60,000 and $39,600 seem miles apart, but we’ll analyze that below.
Work or retire means ‘don’t work here.’ A complex issue for retirees is understanding the overall picture of ‘retirement.’ Under a DB plan, retirement almost always means ‘don’t work here.’ In the example above, the employee would be paid $60,000 by the employer, plus a variety of other costs, like health care, and employer payroll taxes to work; versus having the pension fund pay the employee $39,600 to not work there. ‘Not work here’ can mean a variety of possibilities, including:
· Potentially taking social security
· Getting another full or part-time job
· Using other retirement funds, like §401(k), 403(b) or 457(b)
What the prospective retiree needs to see is the bottom-line comparison of working versus retiring. What is the net income after all taxes, withdrawals and expenses have been applied?
How to analyze a pension decision. To effectively analyze a work or retire decision, we need to do a side-by-side comparison of a paycheck to a pension check. To facilitate the comparison, we’ll build a ‘T-account’ of the moving parts. We’ll run through some examples, and remember, your mileage may vary. It is important to note that every individual’s circumstances differ, so the examples that follow are only examples and are not prescriptive. A thorough, personal analysis should be performed before an individual makes the decision to work or retire.
Let’s continue with our example of the 65-year-old making $60,000. For our example, they are single, and we will apply the average state income taxes. We’re also going to assume they contribute 5% to their 401(k) to get an employer matching contribution. We’ll adjust for federal, state, and payroll taxes, plus the 401(k) contribution and the average costs of having a job, called job-related expenses. This might be union dues, transportation, or other expenses related to being an employee. According to Careerbuilder, this is about $276 a month, so we’ll use that. We’ll assume if they retire, they’ll incur some retirement related expenses of $200 a month (like co-pays).
Basic comparison of monthly income, paycheck vs. pension check. LEON LABRECQUE
If our employee worked 167 hours a month, plus spent 1.5 hours a day commuting and getting to work, the net hourly pay is about $3.16 an hour.
How did this work? Obviously, we made $1,700 less on the top line, but income taxes were less because income was less. You don’t pay Social security or Medicare taxes on a pension check, nor do you contribute to a 401(k) (although you may be taking disbursements). We had a net gain when we compared working versus retirement expenses. All in all, the comparison isn’t so bad, even though it initially may have seemed so. What if we add in Social security?
BASELINE + Social security (monthly)
Basic comparison of monthly income, paycheck vs. pension + social security. LEON LABRECQUE
401(k) Withdrawal. Note that we didn’t consider a 401(k) withdrawal. Needless to say, if the retirement scenario works without the 401(k), it will work with it.
Lump-sums. Another important aspect in looking at retirement in a DB plan is the record low interest rates on lump-sum calculations. The rate used to calculate lump-sums is at a record low, which mean that lump-sum options are at all-time highs. By my calculations, lump sums are about 9% higher this year than last year at this time. Getting a bigger lump sum in a down market can be a big benefit.
The future. It seems obvious that this crisis will affect the pension landscape. In the former (good) market environment, the number of DB plans were falling. Between market damage and economic damage, it seems likely that many employers will freeze or terminate their plans. They may also start requiring or increasing employee contributions to plans. This is probably a good time to look at whether it’s better to have your current employer issue you a paycheck or a pension check. After all, they spend the same.