With a few notable exceptions, the age of pensions largely over in the US Traditional defined benefit plans have been largely replaced by defined contribution retirement vehicles such as 401(k) plans. A a new study from the National Institute on Retirement Securityhowever, it seems to suggest that the end of pensions may not actually be as beneficial for companies as once thought. In fact, providing employees with a traditional pension plan can be less expensive than operating a 401(k) plan or other defined contribution plan.
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Why Are 401(k) Plans More Expensive Than Pensions?
The rationale behind why companies wanted to switch to defined contribution schemes is quite simple. In a traditional pension scheme, the company is on the hook for a predetermined payment each year until an employee dies. If they live particularly long, that can be expensive. With a defined contribution plan like a 401(k), however, the payout is determined entirely by how much an employee has saved during their working years—and if it ends, it's not affects the employer.
However, the group nature of a pension plan can result in lower costs for employers, though, according to a new NIRS study.
“Pensions have economies of scale and risk pools that cannot be replicated by individual savings accounts,” said Dan Doonan, executive director of NIRS, in a statement. “This means pensions can provide retirement benefits at a much lower cost.”
The study found that to replace 54% of workers' post-retirement income, a DB plan required contributions of 16.5% of total payroll. Meanwhile, DC's plan required 32.3% of the payroll to reach the same endpoint.
“These cost differences are a key consideration for employers and policymakers given that most Americans are very concerned about retirement and retirement savings levels are dangerously low for the typical US household,” notes Doonan. “Policymakers are wise to protect existing pensions while also fostering innovation in DC plans to improve the financial security of those who rely on 401(k) accounts.”
A financial advisor It can help you weigh up the trade-offs based on your circumstances.
Pension Scheme Basics
401(k) pensions
A pension scheme works by having money contributed to a fund by the company and employees registered in the scheme. There may be a cliff when a person becomes part of the scheme – meaning you become eligible for benefits after working for the company for a certain period of time.
The money put into the pool is then invested in the market so that it grows. Often either an investment board or a financial adviser will do invest choices. The money from the fund is then used to pay pre-determined amounts of money to retired employees, often based on how long a person has worked at the company and what their salary was while there.
401(k) Plan Basics
A 401(k) plan is much more individualized. Each person contributes money to their own account and chooses from a menu of investment options. Once they retire, they can set up their own drawdown plan to withdraw money as needed. Money contributed to a 401(k) is put in pre-tax, so participants will pay taxes when they withdraw money after retirement.
Sometimes there is an employer component to 401(k) plans — a match employer. This is an option that some employers use as part of a workers' compensation package. Basically, a company will match a certain amount of money that the employee contributes. This could be a dollar-for-dollar match or a potential match, but generally the company only contributes based on how much each employee contributes. Consider consult a financial adviser for professional guidance through legislative changes and beyond.
The Bottom Line
401(k) pensions
For the past few decades, pension schemes have been largely phased out in favor of defined contribution schemes, except in some industries, particularly the public sector. However, new research shows that the conventional wisdom may be wrong and that pension plans may cost employers less than offering a 401(k) plan.
Retirement Planning Tips
No matter what type of retirement plan your company offers, a financial advisor can help you plan for your golden years. Finding a qualified financial advisor doesn't have to be difficult. SmartAsset is free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, start now.
It is important to know how much you will need to live your retirement dreams. Use SmartAsset retirement calculator to see what you will need and if you are on pace to get there.
Keep an emergency fund handy in case you run into unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuation such as the stock market. The trade-off is that the value of liquid money can be eroded by inflation. But a high interest account allows you to earn compound interest. Compare savings accounts from these banks.
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