You Can Take It With You!

When leaving a company, whether because of retirement, a layoff, or pursuing a new job opportunity, you are faced with many financial decisions. Among those are what to do with the retirement assets you accumulated during your employment. You basically have two important decisions to make.

1) Should you roll your 401(k), 403(b) or other retirement plan balances into a rollover IRA?

2) Should you take a lump sum payment or an annuity from your pension?

The first one is easy: the answer in nearly all cases is YES. When you roll your 401(k) or another plan into an IRA, even if you keep it invested in the exact same funds, you avoid administrative fees associated with the company plan. These fees can be as high as 1%. Over a long period of time, these fees really add up. By rolling your money out, you make sure you avoid these fees altogether.

Another reason you should roll your retirement plan into an IRA is that you greatly improve your investment choices. Most plans have only a few mutual funds to choose from and often these do not represent enough asset classes to give you proper diversification. You may also be excluded from using individual stocks. By rolling into an IRA at a discount brokerage firm like TD Waterhouse or Charles Schwab, you have nearly the entire universe of mutual funds to choose from. In addition, if your account is large enough (generally over $200,000), you may benefit from using individual securities instead of funds. (To learn more about the benefits of using individual stocks, see the article “The High Cost of Mutual Funds” in this newsletter and the article “The Case Against Mutual Funds”.)

The second decision is more complicated. Whether to take a lump sum payment or an annuity from your pension depends on a number of factors. Some of the things you will need to consider include:

  • Interest Rates – Current interest rates are used to calculate a lump sum payment that is equivalent to the stream of income you would receive with an annuity. When interest rates are low, as they are now, this calculation produces a larger lump sum payment. In addition, you have an excellent chance of being able to invest your funds at a higher rate of return than the rate used to calculate your lump sum payment. That means that at times like this you can often get more by taking the lump sum payment.
  • Inflation – Most pensions do not provide cost-of-living adjustments to your annuity payments. What may look like a reasonable income today may not provide a sufficient standard of living for you in 10 to 20 years. At 3% inflation, a $2,000 monthly annuity will only be worth about $1,500 in 10 years, and $1,100 in 20 years. You have a better chance of beating inflation by taking a lump sum payment and investing a portion of it in stocks.
  • Risk – One of the benefits of an annuity is that you will probably not outlive it. When you take a lump sum payment, you run the risk of spending down your assets during your lifetime. Whether this is a significant risk for you depends on issues such as your other assets, level of expenses, and risk tolerance.

It is important to seek the advice of a professional when making these important decisions. Be sure to choose someone who has been through the process many times, knows what to look for, and can evaluate your options fairly and objectively.