Deciding Whether to Opt Out
If you’re a Delta pilot, unless you’ve been out on vacation for a month and completely unplugged from the world, you know you have a major decision to make before July 31: whether to opt out of the new Market Based Cash Balance Plan (MBCBP).
We on the Aviation Team at Creative Planning have been working on some considerations to hopefully help aid you in making your decision. Whichever decision you make, similar to the CRM flow charts in briefing rooms at the training center, realize this is NOT a “no-time” emergency, so the age-old adage of “no fast hands in the cockpit” should apply to this situation. From the writing of this article, pilots have roughly 60 days to make their decision, giving you plenty of time to think about what’s right for you and your family after reading this (and consulting any other reputable sources of information you might have access to).
The Delta forums on social media have been alive with commentary since the company’s announcement, and the Delta MEC has been putting out some very useful information detailing plan specifics. Before we go into a list of considerations — as well as some theoretical scenarios our team has come up with — at the risk of repeating what’s already been outlined, we feel it’s worth reviewing the nuts and bolts of the plan for the benefit of those about to make a choice, as well as for future new hires who will have no choice.
For those hired before the cutoff date, there’s not necessarily a right or wrong answer on which way to go — your choice will really come down to what you feel is most important to you, given your individual situation. Please don’t take this article to mean we’re recommending one course of action over another. As a fiduciary, we can only confidently provide recommendations to individuals on a case-by-case basis, as no two situations are the same.
Let’s start by reviewing the two types of plans out there in the corporate world. If you’re already well versed in your understanding of the plan, feel free to skip ahead to Scenario 1.
Types of Employer-Sponsored Retirement Plans
There are two main categories of employer-sponsored retirement plans: defined contribution plans and defined benefit plans. We’ll start with a description of the former, as this is what most employees should be familiar with — in the case of Delta pilots, this is your 401(k). For former military pilots, this could also be your Thrift Savings Plan (if you participated while in the service).
Defined Contribution Plans
The key attribute of a defined contribution plan is that, typically, the employee is primarily responsible for the investment risk and making their own contributions. Delta pilots (and pilots of many other airlines) are rare in that, unlike most other companies in the corporate world that only provide a small match on employee contributions, the company makes a set contribution monthly known as a non-elective contribution (NEC), regardless of whether you contribute on your own.
Think of the 401(k) as a bucket that can only fit a certain amount of contributions annually. The size of that bucket for 2023 is $66,000, and participants essentially have two “faucets” that add contributions to the bucket. The first faucet you have at your disposal is your 401(k) elective deferral contributions — in other words, the contributions you voluntarily pull from your paycheck monthly. For 2023, the IRS will allow an employee to make contributions from their own paycheck up to the amount of $22,500 (or $30,000 if over 50 years old). The contributions can be made pre-tax (traditional) or after-tax (Roth).
Once you max out your own contribution amount, this first faucet gets turned off for the rest of the calendar year. This leaves the second faucet available to you, which comes in the form of those NECs from your company that we mentioned earlier. A pilot can also funnel additional 401(a) contributions from their paychecks through this second faucet. 401(a) contributions don’t count toward the $22,500 limit, go in after-tax, and have earnings that are eventually taxed if not rolled into a Roth IRA. For the purposes of this article’s focus, we’ll forgo the discussion on the pros and cons of 401(a) contributions — for now, just realize how they fit into the 401(k) bucket.
These two faucets are running concurrently throughout any given year, filling up the bucket. Once the bucket in this analogy hits $66,000 for the year, known as a plan’s 415(c) limit, all faucets for the bucket are shut off, as there’s no more room for contributions in the plan. Another way 401(k) contributions might stop is if an employee reaches a compensation level of $330,000, in which case all faucets shut off as well, regardless of how much was in the bucket. Once the faucets are shut off, the company’s NEC still must go somewhere — either into your paycheck or, starting on October 1, 2023, into the MBCBP (depending on whether one has opted out).
Now let’s move on to defined benefit plans, which is where the MBCBP comes into play.
Defined Benefit Plans (Such as the Market Based Cash Balance Plan)
Cash balance plans are a type of defined benefit plan. Different from defined contribution plans, with a defined benefit plan the company — not the employee — takes on the risk to fund the plan and invest those funds. Also, because this type of plan isn’t a defined contribution plan, the plan isn’t subject to the $66,000 limit previously discussed. For those pilots who still carry the scars of lost pensions, fear not — a cash balance plan is different from a traditional pension in that it’s protected from bankruptcy and creditors. Rather than applying a formula to credited years of service that the company had to fund, as with a traditional pension, a cash balance plan has actual dollars contributed to it and set aside for each participant. Even though funds for all participants are comingled in the same company-managed investments, each participant has their own “cash balance” that accumulates like any other investment account they may have. What makes the Delta plan a “market based” plan is that the investments are placed in a traditional mix of stocks and bonds, whereas other standard cash balance plans typically invest in historically low-risk investments like government securities and cash equivalents. In the case of Delta’s plan, the plan will initially be invested in the Blackrock LIRIX Target Date Fund, which has a mix of 40% stock/60% bonds.
For a Delta pilot who opts in to the MBCBP, the plan is funded by the spillover of funds that can no longer fit in the participant’s 401(k). The advantage from a tax perspective is that these funds that would have normally been taxed at the pilot’s highest marginal tax rate and been subject to ALPA dues now escape both burdens and go into the plan tax-deferred, reducing the pilot’s tax burden today (when, conceivably, a pilot will be in their highest lifetime tax bracket). The cons are that these funds are now stuck in a retirement account until at least age 59 ½, and you give investment control of this account to your company. The balance will be treated like pre-tax 401(k) or IRA contributions and will add to your overall required minimum distribution in your seventies.
As a pilot nears retirement, the MBCBP is going to look very similar to a 401(k) or IRA, and it will come with similar options. Starting at 59 ½ years old, a participant will be able to take in-service withdrawals or roll over the balance to an IRA. Participants also have the option to either take a lump sum in retirement or use an annuity option — however, we’ll assume in our discussion moving forward that pilots will elect to move their plan balances to IRAs in retirement.
Scenario 1
It would be impossible for us to create a myriad of different situations that would directly apply to every pilot, so we made some basic assumptions about the profile of our Delta pilot to create a middle-of-the-road scenario for illustration purposes. The first scenario we ran was simply an apples-to-apples comparison of the growth potential of the two different account options, the MBCBP vs. a taxable account. Our assumptions for the scenario are below:
- A 50-year-old pilot is married to a spouse of the same age.
- Income: $350,000/year; maxed out 401(k) with an 18% NEC from Delta
- Annual 401(k) excess contributions:
- Option 1: $20,000/year into the MBCBP
- Option 2: $13,000/year into a taxable account (35% drag due to taxes/ALPA dues)
- For MBCBP projections, we used the 10-year average rate of return for the LIRIX fund, which was 4.16%, and applied this to the plan until age 65. We then assumed that at age 65 the plan balance is rolled into an IRA and, going forward, achieves an average rate of return of 8%.
- For taxable accounts, we assumed a gross 8% rate of return reduced to a net rate of return of 6.4% to account for the annual tax drag of the account (capital gains, dividends and income).
- Required minimum distributions begin at age 75 and are then taxed at a marginal tax rate of 32% and reinvested into a taxable account.
Scenario 1 Results
- At Age 65
- Opt-In: $422, 126 (MBCBP balanced rolled into an IRA at retirement)
- Opt-Out: $331, 937 (invested in taxable account)
- At Age 75
- Opt-In: $911,337 (RMDs then reinvested after taxes)
- Opt-Out: $617,265
- At Age 99
- Opt-In: $3,620,662
- Opt-Out: $2,735,713
From a numbers perspective, the MBCBP wins in this scenario, even when you consider the lower rate of return on the plan during your working years and even when we account for the required minimum distributions that would come as a result at age 75. The initial drag on contributions, as well as the ongoing tax drag, are simply too much for the taxable account to overcome using this time horizon. There are some models floating around that ignore the ongoing tax drag of a taxable account, and it’s important to understand that, realistically, a diversified taxable account is going to have some tax liability every year. At Creative Planning, we’re well versed on advising clients with sizable taxable accounts, so we reduced the rate of return to reflect a realistic tax drag.
It’s worth noting that Scenario 1 isn’t a realistic representation of a pilot’s actual real-life financial planning scenario; we’re just comparing the growth of two different accounts in a vacuum. No goals or spending were baked into the above scenario, and no other factors were considered, such as an existing 401(k) balance, other income in retirement (e.g., Social Security or pensions) or spending needs outside of required minimum distributions. For that reason, we ran a second scenario that more accurately depicts these new factors being considered. The assumptions for Scenario 2 below assume everything applies from our first scenario, but now we add in the additional factors we would consider in an actual financial plan.
Scenario 2
- Our age 50 pilot has an existing 401(k) balance of $750,000.
- The pilot takes Social Security of $3,400/month and has a spouse that will take $1,700/month, both starting at a full retirement age of 67.
- The pilot will retire at age 65 and have a gross spending need of $200,000/year in retirement; these are 2023 numbers and will be indexed for inflation at 2%/year, so the actual spending need starting at retirement will be $269,000/year in future dollars.
- Roughly 20% of the lifetime spending need will be accounted for by Social Security.
- Taxable accounts are spent down first, followed by qualified accounts.
Scenario 2 Results
- At Age 65 (when retirement spending begins)
- Opt-in: $4,956,589 with a surplus of $1,598,175 at retirement
- Opt-out: $4,866,398 with a surplus of $874,638 at retirement
- At Age 75 (when RMDs begin and are in excess of the spending need in this scenario — excess RMDs are reinvested in a taxable account)
- Opt-in: $6,895,107
- Opt-out: $6,698,384
- At Age 99
- Opt-in: $21,879,227
- Opt-out: $18,589,154
In our more realistic Scenario 2, the MBCBP still eeks out ahead of a taxable account. But is it really as straightforward as the above? The answer is almost certainly no. The above examples are not meant to be taken as financial advice but are rather meant to portray the impact various factors can have on one’s long-term plan. Every person’s household situation is like a fingerprint — uniquely its own. And for that reason, there are simply too many variables that can alter any given scenario for us to suggest the above scenarios apply to every reader.
Other Factors
Some of the other factors that are impossible to predict in a generic scenario but could drastically impact an individual’s plan include:
- Will the investor engage in disciplined tax-loss harvesting over time in their taxable account to reduce their overall tax liability? Tax-loss harvesting is an effective strategy that could drastically affect outcomes (but is also impossible to quantify or predict).
- What about estate planning? Does the participant have a spousal beneficiary that can stretch the life of these qualified accounts? If not, does it make more sense to pass on an account with a step-up in basis rather than saddle a non-spousal beneficiary (like an adult child) with an account that must be fully distributed within ten years? Do you have a child with special needs and require a specific set of funds to be set aside in the event of your absence?
- Will the participant be making Roth contributions or initiating Roth conversions in retirement?
- What about shorter-term goals outside of retirement? Will excess contributions need to be accessed earlier than retirement?
- What kind of financial personality is at play? Is the participant a natural over spender who lacks the discipline to invest excess money from their paycheck?
- What about taxes? We know what tax rates are today, but is it safe to assume they’ll be the same 15 or 20 years from now (as history shows that tax rates typically trend higher, not lower)?
In Conclusion
Every flight plan — and every flight — is unique, standing alone. Flight plans are built to account for certain known variables, but as every pilot knows, there are often unforeseen variables that can pop up without notice.
Think of flights you’ve had where unforecasted turbulence forced you into an unplanned altitude change. Or perhaps a flight where a medical emergency forced you into an unplanned divert. Maybe you’ve experienced an enroute equipment failure that affected your ability to shoot certain approaches at your destination. And the list goes on.
The variables in our lives are no different. As one of my old airwing commanders in the Navy once said before we launched on a large force exercise that we had spent a week planning for, “We’ve done a lot of planning up to this point. And the only true thing we can count on with our plan is that our plan is going to change.” Never were truer words uttered, I would argue. What do we do as pilots when our plans change while airborne? We call in our team and confer with them before making any decisions that can have a dramatic impact.
The decision to opt in or opt out is irrevocable and, therefore, significant; it shouldn’t be made in a vacuum. While this article was meant to provide pilots with more insight, it shouldn’t be solely used to make this — or any other — decision. Much like your team at your airline helps you while airborne, we on the Creative Planning Aviation Team help pilots navigate issues like these daily. If you’d like to consult with our team regarding the MBCBP and how this decision fits into your overall financial situation, please schedule a meeting. We’ll be happy to meet with you and become part of your financial team here on the ground.
