As the name implies, a defined benefit plan has a prescribed benefit when you retire. This benefit is often based on some really complex formulas, but, in theory, with some assumptions and some help from HR you should be able to predict what you'll receive in retirement because the benefit is defined. They were designed in the past to keep employees at the same company. Most defined benefit plans pay you a specified amount based on years of service and your earning level during your highest earning years. City and state workers are famous for taking advantage of this last factor, working lots of overtime during the last few years to increase their highest earning years, sometimes retiring with a pension that is higher than their salary when they were working. Most corporate plans, however, base the pension on base salary, not including bonuses or overtime, so this trick will usually not work.
As an example, let's say a plan will pay you, per year, 2% of the average of your highest three salary years for each year you work during your first 20 years with the company, then 1.5% for each year after that. Again, this is an example - all plans have different rules. Let's say that you work for 40 years with the company and that you earn $69,000, $70,000, and $71,000 during your highest earning years (an average of $70,000). You would earn 40% of salary for the first 20 years, then 30% of salary for the last 20 years, for a total of 70% of the average of your highest earning years. When you retired, the pension plan would pay you 70%*$70,000, or $49,000 per year for the rest of your life. Many plans also have spousal benefits where your spouse would get some portion of your benefits (maybe 50% or 100%) for the rest of his/her life after you died.
As you can tell, one issue with the traditional plan is that when you and your spouse die, your benefits stop. There is nothing to leave the children. If you both die a year after retirement, you'll receive almost nothing in pension benefits. If you're lucky and live to be 105, you'll make out like a bandit. To improve the plan, another benefit that some plans (fewer and fewer) offer is a lump sum payout. In this scenario the company pays you a lump sum when you retire, usually based on the amount of money you'd need to put into an annuity to receive the same monthly benefits. This means that the longer an average worker is expected to live, the higher the lumped sum will be, and the higher interest rates are at the time, the lower the benefit. Many plans also put a cap on how low interest rates can be to keep from giving too large a payout. In the current low-interest rate environment, many plans are just dumping the lumped sum option entirely since their payouts are getting too large.
A word of caution is needed here. One of the assumptions needed to predict your benefits at retirement is that the plan will not change. This can be dangerous since, while employers are required (by law) to pay you what you have earned, they are not required to honor any future increases in your benefits. This means they can change the plan for future years even after you have started working. Most employers try to live up to their side of the bargain, but you should not take it for granted that the plan when you turn 65 will be the same as it was when you signed on at 22. For example, let's say you worked for 20 years with the pension plan described in the example above. At that point, the company decides to freeze their pension plan, such that you don't earn any additional benefits. Let's also say that your average salary for the three years before they froze the plan was $40,000 per year. When you retired, you'd receive 40% of $40,000 per year, or $16,000 per year, instead of the $49,000 you were expecting. The company is required to pay what you have earned, but can change the rules for future years at any time.
401K (Defined Contribution) Plans401k plans are defined contribution plans, where the company defines how much they are going to contribute. Virtually all plans require the employee to contribute a portion of their pay to the plan (some pension plans do as well), and then provide a matching contribution. For example, it is fairly common to match what an employee contributes up to 5%, such that if the employee puts in 5%, the company also puts in 5%, such that you're saving 10% of your salary for retirement. You could contribute more of your pay to the plan, but the company would provide a maximum of 5% of your pay. For example, if you contributed 10% of your pay, the company would contribute 5%, for a total of 15% of your pay.
Once the company has put in whatever they agree to add, their part is done. The employee invests the money, using a variety of mutual funds provided by the plan. At retirement, the employee takes control of the money in the plan and is free to withdraw it or roll it over into another account such as an IRA. At that point the employee will usually choose to keep the money invested in funds or buy an annuity to provide a pension-like payment each year. There is no guarantee on how much money will be in the account - hence the term, "defined contribution."
What are the advantages and dangers of a pension plan?Advantage: If nothing is changed, a pension plan has a predictable benefit.
Danger: That benefit can be changed during the working career of the employee. Only already earned benefits are guaranteed.
Advantage: Pension plans are guaranteed by the government if the company pension plan fails. Companies are also required by law to make contributions to the plan to keep account balances at a specified percentage of benefits owed to help keep the plans from failing. This means the plan may still be solvent even if the company goes bankrupt.
Danger: That guarantee will not necessarily cover your full benefit since there are limits. If you have a lavish pension plan, your benefits may be cut significantly if the government takes over. Also, the guarantee will not provide future benefits, just whatever you'd earned when the company failed.
What are the advantages and dangers of a 401k plan?Advantage: The money is in an account you control, allowing you to see how much you have and control how it is invested.
Danger: You're in control, so there is no backup plan if you invest poorly. The worst way you can invest is to put it all in the money market fund. Putting the money into a target-date fund with a date corresponding to when you will retire, if available, or dividing the money into stock and bond funds are both good options. If choosing the latter option, a greater percentage should be in stocks when you're young and about half bonds and half stocks when you're near retirement age. A rule-of-thumb is the percent of bonds you own should be equal to your age minus 10.
Advantage: Every 401k plan is, by definition, a lumped-sum plan. If you die early, even before you retire, you can leave the plan to a spouse or other heirs.
Danger: For whatever reason, the government allows people to make withdrawals from their plan before retirement. Some of these can be without penalty, under special circumstances, but most withdrawals before retirement age come with a 10% penalty, plus normal income tax payments. Many people ruin their finances in retirement by taking the money out of their 401k early and wasting it.
In the next post, we'll look at pension plans from a company perspective and see how they compare with a 401k plan.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.