Choosing the Right Retirement Plan

retire2There are various financial plans that can help you save for a comfortable retirement. However, since all retirement plans have their own features and benefits, it’s not always easy to make a choice. That’s why it’s best to compare as many of the different plans as possible in order to make the right choice for you.

Retirement plans may be categorized as either defined benefit plans or defined contribution plans. A defined benefit plan identifies a specific benefit that will be payable to you at retirement. Your basic retirement benefit is usually based on a formula that takes into account factors like the number of years you’ve worked for an employer (years of service) and your salary (e.g., the average of highest three or five years of earnings).

Your retirement benefit is generally provided in the form of regular payments over your lifetime. The benefits start at what the plan designates a normal retirement age, which is typically age 65. This stream of periodic payments is known as a pension, which is sometimes called an annuity.

“The question isn’t at what age I want to retire, it’s at what income.”- George Foreman (American Boxer)

On the other hand, a defined contribution plan specifies how much money will go into a retirement plan today. The amount is typically either a percentage of an employee’s salary or a specific dollar amount. Those funds are often invested in mutual funds or annuities available inside the retirement plan. Several factors determine the amount you have at retirement:

  •  How much your employer contributes to the plan.
  • How much you as the employee save in the plan.
  • The amount of time you leave those funds invested.
  • How well your investments perform inside the plan.

In this article, we focus on what pensions and 401(k)’s are, as well as the key differences between the two.

When you start a new job, you will have to decide whether you want to be involved in a retirement plan. You might have a couple of options available to you, perhaps including a traditional pension plan (a defined-benefit plan) or a defined-contribution plan, such as a 401(k).

 Pension

PensionA defined-benefit plan will typically pay you a set amount each month after retirement. The calculation for how much you receive depends on how long you’ve been with the company and the amount of salary you end up with.

With a defined-benefit plan, contributions are made, and you are guaranteed a certain outcome. The employer can make contributions to the plan without your help. Otherwise, you can boost your retirement benefit by making your own contributions.

The main point of the defined-benefit plan is that you receive a reliable income source when you retire. The investment risk that might come as a result of the plan is borne by the employer or by the government.

 401(k)

With a 401(k) plan, instead of someone else taking on the risks associated with an investment not doing well, YOU are responsible for the risk. A defined contribution plan means that you and possibly your employer make contributions to your retirement plan. As such, the benefit is entirely dependent on how much you put in, and how the market performs.

Most workers are fairly acquainted with defined contribution plans. This is because defined contribution plans are the most common types of retirement plans nowadays. Your retirement benefit depends on how much you put in, how long you contribute, and how well the investments do over time.

The main drawback to defined contribution plans is that you are at the mercy of the markets. Probably,  you have the ability to choose the investments you hold in your account. If so, a little careful planning can help you offset some of your investment risk. However, if your employer doesn’t offer good choices and you are forced to use high-fee funds it can erode some of your returns.

What choice do I make?

retirement planPension plans have been in existence for a long time, while 401(k)s are gaining in popularity. In fact, the 401(k) will most likely replace pension plans all together in the near future. Yet, there are still employers who offer both pension plans and 401(k) plans.

In light of recent concerns about the markets, as well as worries about how much people contribute to retirement accounts, many people would like to see a return of defined-benefit plans. However, you are unlikely to have that option when you start working with most employers, especially in the private sector. Pensions are few and far between these days.

Not every employer offered pensions, even when they were popular. Before the introduction of 401(k)s, roughly four out of ten people had a pension. As such,  most people didn’t have an efficient way to save for retirement other than sticking it in taxable accounts. These days, most large employers offer 401(k) plans. For those who can’t get access to one, IRAs are available to everybody.

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