When public workers with defined benefit plans leave their jobs, they are usually given the option to either withdraw their accrued retirement savings as a lump sum or keep their retirement account open, to be redeemed upon retirement.
If the employee elects to go the lump-sum route, they can roll that money over into an IRA or simply accept it as taxable income and pay the associated penalty for early withdrawal.
Employees around the country make this decision every day. But it’s one with significant retirement implications, and there’s little understanding as to what drives people to decide one way or the other.
In a paper recently published in the Journal of Public Economics, Robert L. Clark, Melinda Sandler Morrill and David Vanderweide explore the decision-making process.
The basic findings of the paper:
Using administrative data from the North Carolina state and local government retirement systems, we find that over two-thirds of public sector workers under age 50 separating prior to retirement from public plans in North Carolina left their accounts open and did not request a cash distribution from the pension system within one year of separation.
Furthermore, the evidence suggests many separating workers, particularly those with short tenure, may be forgoing substantial monetary benefits due to lack of knowledge, understanding, or accessibility of benefits. We find no evidence of a bias toward cash distributions for public employees in North Carolina.
More detailed findings from the paper:
We find that fewer than one-third of all terminating public employees requested a LS [lump sum] within one year of separation, despite the finding that for over 70% of terminations, the LS was larger than the estimated PDVA. These results indicate a low probability of leakage from retirement funds, although many workers are seemingly forgoing the possibility of higher retirement income possible from rolling over funds to an IRA.
We offer several potential explanations for why the distributional choice from a public pension plan is more complex than a simple wealth comparison at a point in time. First, separating participants in TSERS qualify for retiree health insurance from the State Health Plan with no premium as long as they are receiving a monthly annuity from TSERS…Despite the difference in coverage of retiree health insurance in the two systems, we do not see a large difference in the distributional choices between separating workers that will qualify for retiree health insurance and those that will not.
Second, we consider the likelihood that terminated participants may plan to return to public employment. The expectation of returning to public employment might make maintaining the account the optimal choice for these individuals…
…workers are not responding to incentives of outside investment options. We do find that when the state unemployment rate rises, individuals are significantly less likely to withdraw funds. This could be due to selection into who is separating employment, or it may be that individuals more heavily rely on defaults in times of economic turmoil.
The final explanations we consider for why public sector workers in North Carolina do not withdraw funds at a higher rate are financial literacy, peer effects, and inertia. The default is to leave funds in the system. The behavior we observe is consistent with many individuals accepting the default option and forgoing potentially more valuable benefits.
The paper, titled “Defined benefit pension plan distribution decisions by public sector employees”, can be read in full here.
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