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Making Your Money Last

Rethinking Retirement

What happens when your employer changes the rules in the middle of the game?

Editor's note: This article appears in Kiplinger's special issue Success With Your Money.

If you are counting on receiving a company pension, you may be playing retirement roulette. A pension isn’t just a monthly check or a lump sum to cash out at retirement—it’s the key to doing everything you’ve dreamed about after you quit working. But if your employer changes the rules in the middle of the game, you might have to put your dreams on hold.

That’s what happened to Mabel Harrison-Pigott, a manager at one of Verizon’s regional offices in New Jersey. She bet that her 24-year career with the telecom giant would pay off with a comfortable pension and early retirement. But earlier this year, Verizon froze pension benefits for more than 50,000 of its managers and nonunion workers, leaving Harrison-Pigott, 49, six years short of full retirement credits. Verizon expects to save $3 billion in labor costs over the next ten years. Harrison-Pigott estimates her share will be more than $200,000 in lost pension benefits. “How do you make up for a loss like that at this point?” she asks. “I had planned to retire at 55. Now I expect to work for the rest of my life.”

Verizon’s cost-cutting move used to be reserved for bankrupt corporations trying to stay afloat. But over the past couple of years, nearly 20 profitable corporate giants—among them IBM—have either excluded newly hired employees from participating in their pension plan or ended further pension accruals for workers already on the job.

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What would make IBM and Verizon, each of which reported after-tax earnings of more than $7 billion last year, take such drastic action? Simply put, it’s an attempt to remain competitive with domestic and foreign rivals that have lower labor costs, as well as to offset the rising cost of health insurance. In addition, many companies don’t want to take on the financial risk of having to pay benefits to retirees who could live for decades.

When IBM froze its pension plan, says Alicia Munnell, director of the Center for Retirement Research at Boston College, “that removed the social stigma” and paved the way for other companies to follow suit. If you have a traditional pension plan, you should assume that it will disappear, says Munnell, and be prepared to come up with alternatives.

Caught in the middle

When Verizon announced its pension freeze, it didn’t leave its employees totally out in the cold. The company also announced that it would enhance its 401(k) retirement plan, increasing its contribution from 83 cents to $1.50 for every employee dollar, up to 6% of salary. And Verizon gave employees additional pension credits for age and years of service.

When companies put a freeze on their defined-benefit pension plans, younger workers stand to benefit the most from beefed-up 401(k)s. Not only do they enjoy matching contributions over several decades, but they can take their savings with them if they switch jobs. Older workers with long tenure are often unaffected by the changes because they locked in their pensions under the old rules.

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Harrison-Pigott is among those employees who have the most to lose: the 40- and 50-year-old workers who are unlikely to continue working long enough to make up for the loss. Traditional pension plans feature a big bump-up in benefits at retirement, when a formula based on your age and years of service is applied to your final, high-earning years. When a pension plan such as Verizon’s is frozen, benefits are based on your highest average pay at the time of the freeze. Subsequent raises or promotions don’t count.

Harrison-Pigott, who lives in Kendall Park, N.J., was looking forward to retiring in six years, at age 55, and spending time with her son Michael, now 9, before he goes off to college. “I was beginning to see the light at the end of the tunnel,” she says. “But I only saw it for a little while before it was snatched away.”

When she learned that her retirement was no longer as secure as she expected, she contacted Doug Lockwood, a financial planner and principal with the Harbor Lights Financial Group, in nearby Manasquan, N.J. Although Verizon offered employees personal estimates of their pension benefits under the new rules, Harrison-Pigott wanted an outside opinion.

Lockwood’s first move was to assess the damage. He calculated that under the old system, Harrison-Pigott’s lump-sum pension payout would have been worth about $600,000 at age 55 after 30 years of service. Instead, her pension benefits are now projected at $392,000 at age 62. Although her lump-sum payout would be larger at age 55, thanks to an early-retirement incentive built into the plan, she says it’s not enough to allow her to quit. So now she plans to work seven years longer than she had expected in order to build up the savings in her 401(k).

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Harrison-Pigott had been contributing 6% of her salary to the 401(k) plan—just enough to capture the company match. Lockwood urged her to maximize her contributions. This year, workers can contribute up to $15,000 to a 401(k) or similar retirement plan. If you’re 50 or older, you can put in up to $20,000.

Lockwood also advised Harrison-Pigott to set aside the maximum $4,000 a year in a Roth IRA, which will provide her with tax-free retirement income (withdrawals from a 401(k) are taxed at your top tax rate). If you’re 50 or older, you can contribute up to $5,000 to a Roth or traditional IRA this year. (In order to contribute to a Roth IRA, your income can’t exceed $110,000 if you’re single or $160,000 if you’re married.)

Unlike a defined-benefit pension, a 401(k) requires that you make your own investment decisions—and accept the risks. Lockwood advised Harrison-Pigott to invest 50% of her portfolio in U.S. stocks, 15% in international stocks, 30% in a mix of domestic and international bonds, and 5% in money-market savings. Assuming an average annual return of 7%, Harrison-Pigott could accumulate about $1.3 million—including her frozen pension and company match—if she maximizes her 401(k) contributions and stays on the job for another 13 years, until she turns 62.

Her retirement savings and Social Security benefits, plus those of her husband, John Pigott, will allow the couple to retire comfortably—but far later than they had originally expected and with far less. And the loss to the couple is not just financial, because Harrison-Pigott must also give up her dream of being a full-time mom.

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No guarantees

Harrison-Pigott and other Verizon workers with more than 15 years of service can still look forward to a valuable perk in retirement: subsidized health benefits. But companies large and small have been scaling back retiree health coverage for years. In 2005, only one-third of firms with 1,000 or more employees offered health benefits to future retirees, according to the Kaiser Family Foundation. That’s half the number of companies that offered such coverage in 1988.

The loss of retiree health benefits—which employers offer voluntarily and may rescind at any time—can have a substantial impact on your income needs in retirement, particularly if you retire before you qualify for Medicare at age 65. Fidelity Investments estimates that a 65-year-old couple retiring today without employer-provided health benefits would need $200,000 just to pay for Medicare and medigap premiums and out-of-pocket medical expenses. And that doesn’t include the potential cost of long-term care.

A boost in savings

Even as some firms are retreating from their pension promises, others are stepping up their efforts to help employees save for themselves. Recent innovations in 401(k) plans, such as enrolling new employees automatically and offering professionally managed mutual funds targeted to a specific retirement date, make a big difference. And a new pension-reform law will encourage all employers to offer automatic enrollment as well as personal investment advice. Companies that offer automatic enrollment report a 14% increase in plan participation compared with companies that don’t, according to a survey by Hewitt Associates.

Last year, the average 401(k) account balance grew by more than 10%, to nearly $76,000. And 78% of employees who participated in their company’s 401(k) plan contributed enough of their own money to get the full company match. But the Hewitt survey found that one-third of employees contributed only the amount needed to capture the company match—and that’s not enough. Advisers at T. Rowe Price, a major provider of 401(k) plans, recommend that workers try to save at least 15% of their salary—including employer contributions—right from the beginning of their careers to build adequate retirement savings. If you get a late start, you’ll need to put away even more or plan to work longer.

Munnell says that staying on the job is “a powerful antidote” to reduced income in retirement. “By working until Social Security’s full retirement age or beyond, you don’t incur reduced benefits,” she says. “Your 401(k) balance will build for a few more years, and you’ll reduce the number of years you have to rely on your savings.”

Despite the shock of her pension freeze, Harrison-Pigott now has a game plan to get her retirement back on track. “Workers have to get their heads out of the sand and take control of their retirement savings,” says Lockwood. “The most stressful thing for a potential retiree is not knowing how to get from point A to point B.”