Converting your 401(k) to a pension: pros and cons

The 2014 rule change resulted in the Pension Benefit Guarantee Corporation (PBGC) guaranteeing the transfer of 401(k) balances to eligible pension plans. This means that if a company provides a pension plan, the 401(k) balance can be transferred to the pension, and the pension benefits generated by the transferred balance will be guaranteed by the PBGC, just like the original pension benefits before the rollover.

This will only affect those whose employers offer both types of plans. What are the advantages and disadvantages of doing this type of flip?

Lifetime income

One of the complaints about the current system of defined contribution plans (such as 401(k)) is that, unlike defined benefit plans, it places the responsibility for retirement savings on employees.

Many retirement income experts believe that most participants will have a better life with the kind of guaranteed lifetime income stream provided by pension benefits as an annuity income stream. This relieves participants of the responsibility of managing their retirement assets.

No inflation protection

The rule changes involve corporate pension plans, not municipal, state, and federal government plans. Corporate pensions are rarely linked to inflation through cost of living adjustments (COLA), as are public sector pension plans. Once payments begin, retirees will be affected by inflation on the purchasing power of their monthly payments.

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If the balance remains in the employee’s 401(k) plan account, they may have a chance to get a return on investment, keeping them ahead of inflation. On the other hand, their accounts may lose money in a sluggish market.

In addition, combining a defined benefit plan with a 401(k) plan or similar defined contribution plan is a powerful combination. This provides a means for retirement savers to diversify their sources of retirement income. They can annuitize their monthly pension benefits to provide a guaranteed (or mostly guaranteed) income stream and investment growth opportunities brought about by a fixed contribution plan.

Freeze plan

Many corporate pension plans are freezing their benefits. When this happens, workers can no longer accumulate additional pension benefits based on pension formulas (such as formulas based on income and years of service).

For anyone considering an extension of their 401(k) in whole or in part, this means the risk of turning these dollars into “dead money”. This means that participants may already expect to receive a pension benefit of $401(k) from a pension formula based on years of service and income. In contrast, the previous 401(k) money is now trapped in pension plans, and benefits have stagnated.

If the money stays in the 401(k) plan, at least there is a chance to get future investment income.

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PBGC benefit restrictions

As of 2020, PBGC guarantees annual pension payments of up to US$69,750. If the employer providing the pension goes bankrupt, PBGC is only a factor; otherwise, the pension payment is a company liability like a bank loan.

A nice feature of the new rules is that any funds transferred from a 401(k) to a pension plan are not subject to the annual limit of $67,295. If the pension plan is guaranteed by the PBGC, the employee will receive a monthly annuity payment based on the 401(k) amount transferred to the pension plan, as well as the payment of the original pension plan benefits.

Will this be popular?

CNBC conducted an online reader survey, and 92% of respondents said that they would not consider including 401(k) funds into their employer’s pension plan.

This is not surprising given how popular the lump-sum allocation option in pension plans has traditionally been. Many retirees seem to prefer to transfer to an individual retirement account (IRA) account to better control their retirement reserves. For example, this arrangement provides the flexibility to withdraw the amount and allows the option to leave the money to the heirs through the inherited IRA.

Another factor may be that PBGC is not as well known as the Federal Deposit Insurance Corporation (FDIC), which performs similar functions by insuring bank deposits.

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Should you transfer your 401(k) to a pension fund?

As with most financial planning questions, the answer is that it depends. Everyone’s personal situation is different, but here are some factors for financial advisors to consider for clients.

Are they willing to manage their 401(k) and any subsequent IRA rollovers? If they are faced with the choice of spending as an annuity or a one-time rolling payment, this is always a consideration.

What other retirement resources do they have? Have they already made significant retirement investments outside of their current employer’s plans? This may include IRAs, taxable investments or annuities.

Also, don’t forget to consider their spouse’s retirement plan assets. The social security and pensions of the former employer should also be considered. In short, before deciding whether to transfer your current 401(k) assets to a pension plan, you need to look at the entire retirement situation.

Bottom line

It is difficult to say whether rules that allow employees to include their 401(k) balances in company pension plans will prevail. Although it is well-intentioned, there are many pros and cons that need to be considered. Everyone’s situation is different, so careful analysis is needed.


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