In this post we’re going to take a look at Option 4 of SB1040 (known as Senate Bill 1040), a piece of legislation passed here in Michigan which forces all state school employees to change their retirement pension plans by selecting from one of three options. If you’re just now joining us, you may want to read my SB1040 Introduction post first.
SB1040 Option 4 – Recap:
To summarize SB1040 Option 4, your pension would be frozen and you’d be given the opportunity to start a 401k.
In terms of your pension benefits, your years of service would be frozen at where ever they are right now, and they’d keep the 1.5% multiplier given be this equation:
[Final Average Compensation from Last 3 Years] x 1.5% x [Years of Service] = Annual Pension Payment
Because you’re no longer participating in the pension plan, that means you no longer have to pay a contribution into the pension fund (called the Member Investment Plan or MIP). It could also mean no longer having to pay 3% into the current retiree health care plan if you don’t have enough years in.
In substitution of your pension, you’d start a 401k plan and the State would throw in a contribution of 4% of your compensation! Not too bad!
But there are some stinks. First, if you don’t meet the minimum number of years (15), you’ll no longer be eligible for full retirement health care benefits! That means you’ll be forking out your own cash for health insurance.
Second – Even if you do have 15 years in, you may not be able to start receiving benefits until you’re age 60! That is a big difference from the regular pension where you can start receiving payments as early as age 46 as long as you have 30 years of credit.
1) MIP Deduction:
Because we’re no longer putting money into our pension, we now get to keep that money for ourselves! Given our gross pay and current MIP deduction:
• Current: $2,466.58 x 3.6% x26 pays = $2,308.80
Suppose from now until retirement (13 years), we could either stash that $2,308.80 difference in money in a savings account or invest it in stock market index fund returning an annualized rate of 8% per year. The results of each would be:
• Savings Account: $2,308.80 in 13 years at 0% = $30,014.40
• Investment Account: $2,308.80 in 13 years at 8% = $49,628.34
2) 3% Healthcare Deduction:
In this situation, my wife has her 15 years and she would qualify for retiree health benefits. So our net change in this case is $0.
BUT, what if she didn’t? That means you could save that 3% that all Michigan employees have to pay from their paycheck to fund the health care of current retirees. That’s a contribution of:
• $2,466.58 x 3.0% x26 pays = $1,923.93
Similar to the MIP contributions, we could start off our retirement with:
• Savings Account: $1,923.93 x 13 = $25,011.12
• Investment Account: $1,923.93 in 13 years at 8% = $41,355.50
3) 401k Balance:
SB1040 Option 4 is the only choice where you get to start a 401k plan! Not only can you contribute as much as you wish (up to $17,000 in 2012), the State will also throw in a 4% contribution per paycheck.
Since it wouldn’t be correct in this analysis to look at our own contributions to the 401k (since really we could invest our own money outside of any of these choices), we’re going to focus solely on just the 4% that the State would add since this is basically free money you would have never had before unless you chose this option. That’s an annual contribution of:
• $2,466.58 x 4.0% x26 pays = $2,565.24
Looking from now until retirement (13 years minimum for my wife), we could either stash that money away in a savings account or invest it in stock market index fund returning an annualized rate of 8% per year. The results of each would be:
• Savings Account: $2,565.24 in 13 years at 0% = $33,348.16
• Investment Account: $2,565.24 in 13 years at 8% = $55,140.66
4) Pension to be Earned:
Here’s the unfortunate news. So now that we’ve got a 401k, our pension plan is frozen from this point in time with the 1.5% multiplier. That means we’ll be starting out with a lower Final Average Compensation and fewer years of service.
Estimating a Final Average Compensation of $64,131.08 and 15 years of retirement service, we have:
$64,131.08 x 1.5% x 30 = $14,429.49 of pension income per year
Comparing that to the 1.5% multiplier amount of $32,821.39 per year, that’s a loss of $18,391.90 per year for the rest of retirement! Ouch!
And then there’s the REALLY bad news. Because of the rules of the pension plan, we wouldn’t actually start receiving these payments until age 60 because we only have 15 years of service credit.
5) Health Care Responsibility:
Fortunately, because we have 15 years of service credit, we qualify for retirement pension health benefits. With a 20% responsibility and an estimated cost of $500 per month, our out of pocket contribution would be:
• $500 x 20% x 12 months = $1,200
BUT what if you have less than 15 years? With this option, you will now no longer be covered for retirement health care benefits. That means you will have to take on 100% of the cost out of your own pocket! If you’re years away from Medicare, then that could be a lot more expense than you’re ready to bargain with.
With a 100% responsibility and an estimated cost of $500 per month, our out of pocket contribution would be:
• $500 x 100% x 12 months = $6,000!
SB1040 Option 4 – Summary:
To summarize the results of SB1040 Option 4 (and ignoring the effects of inflation for simplicity), we’d be starting off retirement as follows:
• Gained either $30,014.40 in savings or $49,628.34 in investing due to the difference in increase in MIP contributions.
• Because we qualify, we gained $0 since we made no change in how much we pay into the 3% retiree health care fund.
• Gained an extra $55,140.66 in 401k balance from the State contributions.
• Commit to only receiving a very reduced benefit of $18,391.90 each year in pension income for the rest of our lives. This benefit would also not start for us until age 60.
• Because we qualify, commit to paying an estimated $1,200 each year for health care benefits for the rest of our lives (or until Medicare).
To be honest, I only see a few ups and a lot of downs to this option.
Clearly this option puts more money in your pocket in the present and gives you an opportunity to take matters into your own hands. But what if you aren’t disciplined enough to actual save the difference? What if your 401k plan doesn’t return 8% as this model is using?
And then when you finally do retire, your pension payments are slashed way down to $1,533 per month! That’s quite a fall from where they could have been. Not to mention they don’t start until age 60? This is not looking favorable …
In the final chapter, we’ll put everything together and draw some conclusions about which of these plans are truly the best for our situation.
Image Credit: Microsoft Clip Art