Pension plans and other defined-benefit plans have been going by the wayside in favor of defined-contribution plans such as 401(k)s and IRAs. Learn why and what you can do.
Many companies instead offer “defined contribution” plans such as 401(k)s or 403(b)s
Learn how to best utilize the benefits of 401(k) plans and IRAs, including pension rollovers
These days, when the subject of retirement savings comes up, your first thought might be Social Security, plus a company 401(k) plan or an Individual Retirement Account (IRA). What’s often not in this financial picture? The venerable pension plan—once a staple of employee benefit packages that’s increasingly going by the wayside.
Why the change? What might this mean for your retirement savings? And what if you do have a pension? Some companies are closing them out and distributing lump sums to participants. What should you do if that were to happen? Here are answers to some of the top questions on pensions, 401(k)s, and IRAs.
Pensions are a type of “defined benefit” plan. Typically, you’d pay into it (or technically your employer would pay into it on your behalf) during your working years, and once you retired, you’d have a guaranteed income stream for life.
Such benefits are considered “defined” because the employer must pay each of its retirees the specified amount each month—no matter how the investment performs. If the investment doesn’t cover the defined benefit payment to the employee, then the employer is usually responsible for funding the difference. Thus, employees can rely on regular payments throughout their retirement.
The investments that support the pension plan may vary. Primarily, the employer is required to make regular contributions to a pool of funds that is invested on the employee’s behalf. Sometimes employees can voluntarily contribute to their own pensions. Employer contributions are made based on factors specific to each plan, but usually older workers receive larger contributions because they are closer to retirement, when they will receive the pension payment.
And that’s why companies have been closing down their plans. Many found their pensions to be cumbersome, risky, and expensive—the company had to pay into the plan in addition to an employee’s salary, and then they faced an additional expense if the investment didn’t perform well enough to fund the promised payments. Sometimes when investments were doing well, the company might not be able to contribute much or anything to the pension. This reduced or eliminated their tax deduction. But when their business and the investments were not doing well, they faced increased contribution requirements.
But although pension plans are increasingly rare, they’re still a crucial component of many investors’ retirement plans, especially for public sector employees.
Today, most companies have turned to other, less costly methods for helping their workers prepare for their golden years.
“Defined contribution” plans like 401(k)s encourage employees to save on their own while offering tax-deferred savings features. Plus, employers often match a percentage of their employees’ contributions, which both encourages them to save more and provides an added benefit in the form of additional money from the employer in excess of a salary.
In addition to tax-deferred savings and a possible company match, there’s another benefit to the shift from defined benefit to defined contribution: job-hopping. It used to be the norm for someone to work an entire career at one company. Today, many or most workers move to different companies throughout their careers. They may spend significant time at several companies before retiring. So pensions, which vary significantly from company to company, simply don’t make as much sense in today’s workplace.
But there’s a potential negative side to the switch from defined benefit to defined contribution: The investment risk has shifted to you, the retirement saver. It’s up to you to ensure you have sufficient savings and income streams to last you through your retirement years. It’s also very difficult to know if you have saved enough for retirement. How much income will your savings actually generate each month in retirement? It might be less than you think.
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Private companies have generally stopped offering defined benefits by phasing them out over time. Some employees may be grandfathered into a full pension plan, while others may have access only to a partial plan. Such income may not cover all the expenses of retirement, so employees should consider supplemental savings plans. If your company is changing its retirement plan from a defined benefit to a defined contribution plan such as a 401(k), it’s important to get the details. Specifically:
Lump-sum distributions? Will you be getting a distribution based on the amount the company contributed to the pension plan on your behalf? If so, and if you’ve been with the company a long time, this could be a sizable sum.
New company plan? If your company is moving to a 401(k) plan, you might be able to deposit any pension proceeds directly into the new plan and start contributions right away. With a traditional 401(k), you can make pre-tax salary deferral contributions that will be taxed later, when you withdraw the money. Or, with a Roth 401(k), you can make contributions that have been taxed, and then any gains aren’t taxed when the funds are withdrawn later. Tax savings with either version of the 401(k) can be substantial.
Matching contributions? As an extra benefit and incentive to save, employers often offer a matching contribution, usually a percentage of your salary. These contributions may be vested immediately (meaning they become yours to keep even if you leave the company), or they may gradually vest over time. One common vesting schedule is 20% increments over five years, so once you’ve been with a company for five years, 100% of your matched contributions stay with you.
Rollover alternatives? Depending on your situation, you might consider rolling any proceeds into an IRA, as there could be some advantages. For example, IRA fees are often lower than those of a 401(k) plan. Plus, you’ll likely gain access to a wider range of investment choices than you would in a 401(k). But there are some potential downsides. For example, you won’t be able to take out a loan against your IRA, as you could with a 401(k). There may be trading commissions associated with IRA investments, and the exact same investments might not be available to you. Speak with a qualified tax and/or investment professional and weigh the alternatives carefully before deciding whether an IRA rollover is right for you.
If your employer offers a 401(k) plan, try to take advantage of it, especially if you can get a matching contribution. If you’re not taking advantage of that match, you’re basically leaving money on the table. Contributing to a traditional 401(k) plan can lower your taxes because the contributions are made before your income is taxed. Essentially, your overall taxable income is reduced.
And remember: Typically, 401(k) contributions are withdrawn automatically from your paycheck, so you can “set it and forget it.” This helps you save without thinking about it.
One of the most important strategies with retirement accounts is to avoid withdrawing the funds early. Try not to cash out. Either keep your money in a 401(k) account, move it to your next 401(k), or roll it over to an IRA, where it can continue to grow tax advantaged. Otherwise, you’re missing the potential benefits of compounding.
So, although pensions and other defined benefit plans may be going by the wayside, investors do have several alternative retirement strategies to help them pursue their financial needs in retirement.
And if you happen to be among the dwindling number of workers expecting a pension when you retire? Congratulations! But remember, the pension may not cover all of your needs in retirement. You may want to consider making additional contributions to an IRA. Then you can count your pensions and investments together when estimating your retirement income.
Maximum contribution limits cannot be exceeded. Contribution limits provided are based on federal law as stated in the Internal Revenue Code.
Applicable state law may be different. TD Ameritrade does not provide legal or tax advice. Please consult your legal or tax advisor before contributing to your IRA.
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