Pensions - Vesting and Distribution Options

Part 2: Vesting and Distribution Options

In Part 1 of this series, we discussed the types of pension structures that are available. We also defined the role of the Pension Benefit Guaranty Corporation (PBGC). In this article, we shall look at pension vesting as well as the options that you may have for the distribution of your pension benefits.

With any pension plan, you must be concerned with vesting. Vesting is the amount of time that you must work in order to earn a non-forfeitable right to your accrued benefit. Once you are fully vested, the accrued benefit is yours, even if you cannot collect it at that particular moment in time. The plan will have rules which stipulate when the employer’s contribution will vest.

All pension plans must comply with the Employee Retirement Income Security Act of 1974 (ERISA), which establishes guidelines regarding pensions and other matters, such as minimum standards for vesting. Individual plans may provide for a different standard, as long as it’s more generous than the minimum required by ERISA.

Generally, there are two types of vesting schedules. One is a seven-year graded schedule, which provides for the following vesting levels: up to three years of employment, vesting is at 0%; at least three years but less than four, vesting is 20%; at least four but less than five, 40% vesting; at least five but less than six, 60% vesting; at least six but less than seven, 80%; and at least seven years of employment; 100% or full vesting.

The second type of vesting schedule is known as cliff vesting. In essence, cliff vesting is all-or-nothing. For example, a five-year cliff vesting schedule would stipulate that the full benefit must vest once the employee has completed at least five years of service with the employer. If he or she leaves before that time, all of the pension benefits are forfeited.

If you’re looking forward to receiving a pension from a defined benefit plan, it probably will not do you much good if you’ll be retiring early. With many plans, you can’t begin receiving benefits until you reach a traditional retirement age. If you are allowed to collect early, the amount will probably be much less than it would be had you waited. Also, with many plans, you have the option of receiving a lump-sum distribution of your benefit.

Some experts recommend taking a lump-sum distribution and rolling it over into an IRA. With the proper investments, they feel that you may be able to make much more each month than you would in pension benefits. Another argument in favor of taking a lump-sum payout is the survivorship issue. For example, with some plans, you may qualify for a pension after seven years, but benefits for your spouse aren’t guaranteed until you’ve been employed for a longer period of time. As a result, if you die before that time period your spouse will not be able to collect.

This issue differs from the pension max scenario. Here, the employee opts to take a larger monthly pension benefit. In exchange for this larger pension check, however, the spouse gives up any survivor pension, which could cause serious financial problems when the employee is deceased.

If you’re not married or your spouse is entitled to a survivor’s pension, the lump-sum payout may not be the best option for you. For example, if you’re scheduled to receive a fixed income for life from a defined benefit plan, even a modest one, then you can build the rest of your investment portfolio around it. You’ll be able to reduce your risk by diversification. The pension can be used as the conservative element of your investment portfolio. You can then supplement it with riskier, and potentially more lucrative, investments.

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