Ah, retirement. If you had to rank each word in the language on appeal, retirement must be bottom 1%.
The thing everyone knows they have to prepare for but the majority of people feel like it is so distant you can’t even comprehend.
Historically in the United States, retirement was cushioned by employers offering pension plans and the government Social Security program. A smaller part was made up by personal savings, but for the most part employer pension plans were commonplace and paid well and Social Security was the benefit you paid into your entire working career that would support you in old age.
Pension Plans (Defined Benefit)
In a pension there is a set formula, typically a combination of service and pay. Employees do not pay into these plans, contributions are made by employers. As you accumulate years with your employer, your pension continues to grow.
Your pension dollars technically are not in an individual account with your name on it at this point, it is lumped together in one pension fund with the other employees. In years where the economy does well and the investments have positive returns, the overall pension fund rises. In years where the investments take a loss, the employer is responsible to make up that difference since the worker is promised that formula.
Ever heard that a pension is X% funded?This shows how well funded it is based on what the employer owes each employee based on the formulas. For example, a pension can be over 100% funded because the employer made the contributions attributable to each employee and the investments had positive returns. Say a pension fund is 85% funded, the employees are still due that amount due from the calculation regardless of how funded it is. This is where the burden falls on the employer and they must make an additional contribution to make up for the loss.
A common practice now for employers is to freeze the pension plan (if they offered one). A soft freeze is when current employees will continue to accumulate a pension but new employees after a certain date will not be offered it. A hard freeze is when the pension stops being funded altogether.
401(k) Plans (Defined Contribution)
Today, employers are migrating from offering pensions to 401(k) plans. The main reason being that the investment burden falls on the employer and the expense of maintaining them.
In 401(k) plans contributions are made by employee. With these tax favored accounts, contributions are made pre-tax. Employers typically offer to contribute to your retirement through a match or a nonelective (also known as profit-sharing) contribution. For example, an employer may offer a 50% match up to 6% of your pay. This means that for every dollar you contribute to your 401(k) plan, your employer will give you $.50 up to 6% of your pay. If you make $50,000 and contribute 6%, or $3,000, your employer will contribute $1,500. A nonelective contribution is when an employer contributes a certain amount regardless of what you contribute.
One of the key differences from the pension is these dollars are set aside in your own account from day 1. What this also means is if the stock market is rocking, you win. If the stock market dips, your 401(k) dips and your employer is not responsible for any additional contributions.
Other Types of Employer Plans?
401(k) plans are the most common defined contribution plans and are used by public and private for-profit employers. 403(b) plans are used by tax exempt organizations (such as schools, hospitals, and churches). 457(b) plans are usedfor state and local government agencies. These are very similar to 401(k) plans with pre-tax contributions by both employer and employee.
Don’t have retirement benefits offered through your employer? Don’t panic. There are still options for you. We will review those in Part 2 of Retirement 101.