Switch would require saving $299,536

Your Money

September 24, 2006|By Pamela Yip | Pamela Yip,McClatchy-Tribune

Jack VanDerhei, a fellow at the Employee Benefit Research Institute, provided an example of how much money would have to be added to a 401(k) account to replace the benefits that stop accruing in a frozen pension plan.

The example involves a worker who starts participating in a defined-benefit pension plan at age 30 and plans to retire at age 65. That plan provides a benefit accrual of 1 percent per year of participation, times the average of the final three years of compensation.

This year, when the worker is age 50 and earning $70,000, his employer freezes the pension plan and replaces it with a 401(k).

The worker has a constant salary growth of 3 percent per year, so his final year's salary at age 64 would be $105,881, and the final three-year average compensation would be $102,827.

That would have provided an annual pension benefit of $35,989 beginning at age 65 if the pension plan hadn't been frozen.

However, the employee's final three-year average compensation at the time the plan is frozen is $67,980, so the accrued benefit will be $13,596 per year beginning at age 65.

The difference of $22,393 would need to be made up by purchasing an annuity at age 65 with the proceeds of the 401(k) balance.

VanDerhei assumed an annuity purchase price per dollar of $13.38, meaning that for every dollar of annual income you want starting at age 65, you would have to pay $13.38. This figure reflects your life expectancy, the annuity company's profit, and the returns it expects to get investing your money.

The bottom line?

The employee would need to accumulate an additional $299,536 in his 401(k) plan in his final 15 years of work to purchase this annuity.

To accumulate that much money, the contribution to his new 401(k) would have to amount to 12.9 percent of his income for the next 15 years. If a company match makes up some or all of that, all the better.

If not, at a $70,000 salary, the 50-year-old is looking at a loss of about $9,000 of spending power in current dollars every year until he's 65 - in other words, a 12.9 percent pay cut.

The MATH

If the pension weren't frozen at age 65

Final three-year average:

Compensation $102,827

Annual pension benefit $35,989

But if the pension is frozen at age 50

Final three-year average:

Compensation: $67,980

Annual pension benefit: $13,596

Annual pension benefit shortfall: $35,989 minus $13,596 equals $22,393

Cost of an annuity that would pay $22,393 a year starting at 65: $299,536

Percentage of income needed to go into 401(k) each year to accumulate that amount by 65, assuming average returns: 12.9 percent

Required annual contribution at age 50, with income of $70,000: $9,030

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