Commentary by Joe Clark
Employers typically offer their employees two primary retirement account options: “defined contribution” plans and “defined benefit” plans. Defined contribution accounts permit employees to designate a percentage of their income to be withheld from each paycheck and placed into an account for their retirement. Generally, the employer also contributes a percentage of the employee’s income into the plan.
The other type of retirement plan is the “defined benefit” plan. In this situation, the employer has only an idea of the amount it will provide upon an employee’s retirement, based on the employee’s years of service, age and income. While the company faces numerous “unknowns” based on model assumptions, the employee has a good idea of their retirement income.
The number of defined benefit plans has dramatically declined as 401k plans have taken the lead. Defined benefit plans present greater uncertainty for companies offering such plans. When will an employee retire and how long will they live? What will their income be? Determining how much an employer needs to contribute becomes a formula based on assumptions. And we all know assumptions can be dangerous!
Defined contribution plans leaves less uncertainty for employers. Companies know precisely how much money they must contribute annually and investment results are off the employer’s plate. While these plans shift more risk of the unknown to the employee, many individuals welcome managing their retirement strategy.
Should defined benefit plan participants cash out for a lump sum when they become eligible to do so? The company plan must consider the employee’s current age, as well as the current investment and interest rate environment to calculate the funds needed to satisfy an actuarial benefit.
Many company plans offer employees the choice to take the actuarial benefit cash and roll it into an IRA with no present taxation, or take a lump payment and pay the taxes. A myriad of variables must be considered including a person’s health, investment approach, tax bracket and income needed today verses the future.
The decision to pick the pile of cash today or the income stream forever isn’t easy and should never be made lightly.