By David Brandolph
April is financial literacy month. That is why you are likely to see publications offering articles with financial planning recommendations such as: set goals, track spending, boost savings, and understand concepts such as “diversification” and “compound interest.” Some articles may suggest that you can “become a millionaire” by the time you reach Social Security age if you follow the authors’ advice.
Although these articles can be very helpful, we have decided to take a different path. Instead of the standard advice, we will offer a multi part series discussing financial questions that you may not find elsewhere that will tell you what you need to know if you have access to a retirement plan at work and hope to one day have a secure and dignified retirement.
In this, the first part of the series, we will answer one of the top five questions that people looking for a secure retirement commonly ask to the Pension Rights Center. Unless stated otherwise, answers relate to company or union sponsored private-sector retirement plans. We believe that being financially literate about your retirement plan is likely to pay off for your future.
For workers who qualify for benefits, a pension plan (also known as a defined benefit plan) is the best financial tool available for achieving a secure retirement. Pension plans are set up by an employer (or by a group of employers and a union) and they typically provide lifetime guaranteed income at retirement age based on the number of years you work and a percentage of your salary. Employees do not have to decide whether to put money into most private-sector pension plans. The contributions are made by employers as part of the wage package. Workers who have defined benefit plans are fortunate because they will never have to worry about outliving their income.
Unfortunately, fewer employers are offering defined benefit pension plans these days. They most commonly are found in unionized industries in the private sector and among state, local and federal employers. In a recent issue brief, the RRF Foundation for Aging said that “The private sector has not sufficiently supported workers’ savings, and pensions, envisioned as a critical pillar of late life security, are increasingly rare.” For more information on this, we have a chart that shows how many American workers participate in retirement plans.
Retirement savings plans such as 401(k) plans (also known as defined contribution plans) provide benefits based on the amounts contributed and investment earnings. Since these savings accounts are meant to provide retirement income, early withdrawals before age 59-1/2 will usually result in a 10 percent penalty tax. In most retirement savings plans, workers choose whether they want to put money in the plan. To encourage contributions, many employers offer to match their employees’ contributions.
One important difference between a pension plan and a retirement savings plan involves who bears the risk of potential investment loss. In a retirement savings plan, a worker typically chooses among different investment options and bears the risk of any losses. In other words, individual workers must decide whether and how much to contribute and which investment strategies to use, and then come up with a sensible strategy to make sure that their money lasts through their retirement years. They are fully responsible for ensuring their lifetime income.
In a pension plan, that risk falls entirely on those who fund the plan, usually the employer, which must pay a specific benefit under a formula set by the plan’s consultants, no matter how the plan’s investments perform. The federal Pension Benefit Guaranty Corporation provides insurance protection for most defined benefit pension plans that are unable to pay what they have promised. This protection covers a worker’s pension benefits up to a set limit. If a plan decides to sell plan assets to an insurance annuity provider, which it has the legal right to do, retirees’ annuity payments will be paid by the insurance company. If the insurance company becomes insolvent, retirees will receive protection up to the limits prescribed by their state’s insurance guarantee fund.
There is no federal or state insurance protection for assets in retirement savings plans.
The U.S. Department of Labor has a fact sheet that explains the differences between pensions and retirement savings plans, such as 401(k), profit sharing, and 403(b) plans.