The impact of changing jobs upon pension benefits. (Personal Financial Planning)by Kee, Robert C.
Your client has just received an attractive job offer from another company. He or she is reasonably satisfied with the position currently held. What advice should you give? The decision rests upon a multitude of variables: family factors, financial aspects, conditions required by the employment such as a move, nature of the work, advancement possibilities as well as professional and personal development plus many other considerations. This artcle examines the impact that changing jobs has on the annual pension at retirement.
Determinants of Pension
Company retirement formats range greatly--including defined benefit plans, defined contribution plans, and ESOPS. Additionally, given any one type such as a defined benefit plan, the computation of the benefit differs widely from company to company. For purposes of discussion, we will assume that all company retirement plans are the same: companies have defined benefit pension plans in which the benefits at retirement are calculated according to the following rules:
1. The plans have a five-year "cliff" (all or none) vesting;
2. The company pension is based on the salary earned in the last year of employment; and
3. The pension fraction is 2% per year worked.
Thus, if vested, an employee's retirement is calculated by taking the last year's salary and multiplying by 2% for each year of eligible service. In the case of a retiree who worked for Company A for a few years and for Company B for the remainder of his or her career, the retiree would receive two pensions. The first pension would be based on the number of years of service at Company A times 2% multiplied by the last year's salary earned at Company A. The second pension would be computed exactly the same way except that it would be based on the years of service and the salary earned in the last year at Company B.
For example, if an employee left Company A when his salary was $40,000 after working 15 years and after becoming fully vested, to take a job with Company B for 25 years and then retired when his salary was $80,000, the annual pension would be as follows:
Mathematical Expression Omitted
Several points are worth noting. First is the fact that if this same employee worked for either Company A or for Company B for all 40 years and retired at the same $80,000 salary, the total annual pension would be $64,000 ($80,000 X .02 X 40) or $12,000 more per year. Thus, the $12,000 annual loss of an amount of pension represents the cost of switching jobs.
The second point worth noting is that in the case of the employee above the "lock-in" of pension at an early (lower) salary created the $12,000 difference in pension. This freeze of the salary variable of the pension formula at an earlier, lower salary amount means that the employee loses some of the benefit of a higher ending salary (for the years worked on the first job). If there had been no salary increases over the years since leaving the first job, then the salary "lock-in" would have no impact on the pension. It is the increase in salary over the career that causes the loss of pension from changing jobs. Because workers' salaries tend to rise over their careers, whether from inflation or from merit, job switching causes pension losses. The loss of pension must be balanced against possible higher salary from changing jobs.
Last, it should be noted that switching jobs without vesting is extremely costly, particularly at the time just prior to vesting. Because most companies have "qualified" plans (qualified for favorable tax treatment), full vesting for these qualified plans must be no shorter than five years. This is known as "cliff" or "all or none" vesting. An employer can also qualify its pension with other vesting schedules that include partial vesting (the employee is credited for less than the full 2% if the employee works for a period shorter than the full vesting period). Given a series of employments with a five- year cliff-vesting schedule, an employee, by job hopping, could end up with no pension. When compared to the one-job career described above, the cost of frequent job hopping is $64,000 in annual pension.
Figure 1 serves to illustrate the annual total pension of a person who has two jobs throughout a 40-year career. The top curve in this figure is based on a 6% annual growth in salary, with an initial salary of $20,000 (ending salary: $205,714). Further, it assumes that full vesting is at the end of five years of employment and that pension benefits accrue at a rate of 2% per year of employment.
As displayed by the top curve in Figure 1, the highest benefit is achieved when 40 years is spent on job 1 (and no years on job 2). This is depicted as the far right end point on the "U" shaped curve, where annual pension is $164,571 ($205,714 X .02 x 40 years). At the other extreme, the fair left point on the X axis, spending one year (and not vesting) while spending 39 years on job 2, produces almost as large a pension ($160,457) or $4,114 (2% of $205,741) less than the maximum. Reversing the combination, 39 years on the first job and one year on the second job, produces the same 78% (2% X 39 years) but it is multiplied by 6% less final salary. Thus, working all but the last year of a 40- year career at the first job is more costly than the reverse combination of employment years (pension amounts of $151,375 versus $160,457 or $164,571).
As the graph depitcs, the "U" shape curve is initially downward sloping--the longer an employee works before switching, the greater the loss of pension. This is due to the lock-in effect on pension from the first job. The loss of pension is greatest when the job change occurs after 24 years on the first job. However, as an employee stays on the first job, eventually the pension loss from the lock-in effect is diminished.
The kinks in the "U" shaped curve, which occur at year 5 and year 35 in Figure 1 merely reflect the effect of cliff vesting. These two points represent two particularly bad times to change jobs from a pension standpoint.
Fractional Interest Rule
Many pension plans have fractional interest rules (FIR) that penalize younger, vested workers who leave the first job early in their careers. Instead of earning a full 2% times the number of years multiplied by the final salary, plans with fractional interest rules further multiply the pension by the ratio of number of years on the job divided by the number of years until expected retirement, measured from the day the employee came to work.
Therefore, a 30-year-old worker who changes jobs after five years vested at Company X and a last year salary of $30,000 would, absent the fractional interest rule, expect a $3,000 annual retirement ($30,000 x .02 X 5 years) from Company X upon reaching age 65. Instead, the fractional interest rule reduces the $3,000 amount to the fraction of five years (time with Company X) divided by 40 years (the number of years that the employee could have worked at Company X until retirement). Thus, instead of a $3,000 annual pension, the pension from Company X is only 1/8 or $375 per year.
While the fractional interest rules severely penalize the younger worker who leaves after vesting, the same worker who is 55 when he starts with the company, works for the same five-year period for the same $30,000 salary, earns an annual pension of $1,500 ($30,000 X .02 X 5 years) X (5 years worked/10 years that could have been worked at the company until retirement). Working during the years near retirement boosts the fraction (decreases the denominator) as does the longer the time spent with the company (increases the numerator). Thus, as the fractional interest examples reveal, the five years worked by the 60- year-old (employed from ages 55 to 60) is worth four times the accrued pension for the time worked by an employee from ages 25 to 30; working from ages 60 to 65 is worth eight times as much as between ages 25 to 30 and twice as much as working from ages 55 to 60. Figure 1 depicts the impact of the fractional interest rule on pensions. As shown by the lower curve, the fractional interest rule can be very costly for job changes in the early and mid-years of a career. Leaving an employer that has a pension plan with a fractional interest provision can prove to be very expensive regarding the future annual retirement.
The Salary Equivalent to the
Pension Loss From a Job Change
The next matter to advise your client about concerns the amount of additional salary from the new job that an employee needs to make up for the loss of pension from the job change. By using a present value analysis, an employee can compare the annual salary amount needed on the new job to be economically as well off as keeping his or her old job. This comparison will help determine if the job change makes economic sense.
The two factors that enter in the computation of lost pension benefit in a job change are life expectancy and discount rate. The impact of changing jobs is relatively greater the longer the life expectancy and the lower the discount rate.
The pension loss from job change is the difference in the present value of the pension at retirement if the new job is taken versus the present value of a pension at retirement if no change is made. This loss in the present value of the pension depends not only on the number of years that the pension is expected to be paid, but also depends on when the job change occurs, i.e., how many years were worked at the first and second jobs and at what salaries. These variables are taken into account to determine the additional annual salary that will be equivalent to the loss in pension from job hopping. These annual salary equivalents are depicted in Figure 2. For clarity of illustration, the figure shows the salary equivalent amounts for job changes that occur the first half of a 40-year career. The annual salary equivalents represent the amount of an annuity which, if placed on deposit at the discount rate, will equal the present value at date of retirement of the lost pension. Again a 6% discount rate is used. As shown in the figures, the incremental salary needed to cover the pension loss is very small if the job change is occurring early in one's career. However, the additional salary equivalency amounts rise sharply, such that if a job change is contemplated later in an employee's career, a very large additional salary amount is needed to make the employee whole from the loss of pension benefits.
The incremental salary amount to offset the pension loss is small for a job change early in one's career because there are many years of work remaining to recover the pension loss due to the time value of money. On the other hand, for older workers the additional salary needed to compensate for pension loss from changing jobs is much greater. This large salary equivalent is due to the fact that the worker has so few years to earn back the loss, and the time to retirement is relatively short.
A job change can be costly on the ultimate level of annual pension paid at retirement. This loss of pension should be considered in the job change decision. By quantifying the impact that changing jobs has on annual pension at retirement, the employee can then calculate the salary equivalent: the annual amount for remaining-working years that is equivalent in time value of money terms to the future value amount at retirement of the pension loss.
By William D. Samson, PhD, CPA, KPMG Peat Marwick Fellow and Associate Professor, and Robert C. Kee, DBA, CMA, Associate Professor, both at the Culverhouse School of Accountancy, University of Alabama
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