There was a time when retirees could count on guaranteed lifetime income from Social Security and an employer pension to fund their golden years. Those days are long gone, though. While today’s retirees still enjoy Social Security income, very few have access to a pension. In 1998 nearly 60 percent of Fortune 500 companies offered a pension. As of 2015 fewer than 20 percent offer one.1
Still, there are some employers that offer their employees pensions, also known as defined-benefit plans. The 401(k) is the standard when it comes to retirement benefits, but the defined-benefit plan hasn’t gone totally extinct yet.
You may be in a position where you’re deciding between new jobs, in which one offers a pension and the other a 401(k). Or perhaps you have both a pension and a 401(k) among your retirement assets, and you’re not sure how to plan for them.
The differences between defined-benefit plans and defined-contribution plans, such as 401(k)s, can be subtle, but they’re significant. If you have access to both, it’s important to understand how they work and how they can impact your retirement. Below are a few key points to consider as you plan for your retirement:
Defined-benefit plans are commonly known as pensions. They’re called defined-benefit plans because the outcome of the plan, or the benefit, is known and certain. Your employer provides you with a retirement benefit after you exit your career. That benefit amount usually is based on salary, length of service and other factors.
In most cases, the benefit is guaranteed for life. However, there can be other options available. You may be able to take your benefit in a discounted lump sum. Or you may be able to take a reduced benefit amount but extend the payment over the lives of both you and your spouse.
Obviously, the appeal of a pension is that the benefit is guaranteed and it’s predictable. Many retirees like the certainty of having a consistent income payment arrive every month. However, pensions may offer little in the way of growth opportunity.
Also, some companies have shut down their pensions even for active participants. There are usually legal options available for participants in this scenario, but those processes could take years. Pensions are generally considered to be guaranteed, but there could still be an element of risk.
In defined-contribution plans, the benefit isn’t known, but the input or contribution is. You control how much money goes into the plan, but you can’t control exactly how much comes out in the future.
With defined-contribution plans, such as 401(k)s and 403(b)s, you decide how much money to contribute from your paycheck. The contribution is made with pretax dollars, which reduces your taxable income. Your employer may make a matching contribution. You then invest those funds according to your goals and risk tolerance.
The idea is that the funds will grow in the future. All growth is tax-deferred, which means you don’t pay taxes on the growth as long as the funds stay in the account. When you retire and start taking distributions, the withdrawals are taxed as income.
One of the challenges with a defined-contribution plan is that the withdrawals aren’t guaranteed. It’s possible that you could drain your assets because of market losses or excessive spending. If you outlive your money, there may be no safety net. Defined contributions may also give you greater upside opportunity, however, and they allow you to control how much money you put toward retirement.
Best of Both Worlds
There may be opportunities to take advantage of the best parts of both types of plans. While you may use a 401(k) to accumulate assets, that doesn’t mean you have to use the 401(k) to fund your distributions.
Upon retirement, you could roll your 401(k) into an IRA, and then use a portion of those funds to purchase an annuity. Many annuities have guaranteed lifetime income features that give you a predictable income stream that will last as long as you live. You get the upside savings potential of a 401(k) with the consistent income you may want in retirement.
Ready to plan your retirement strategy? Let’s talk about it. Contact us today at Bridgeriver Advisors. We can help you analyze your needs and goals, and then develop a plan. Let’s connect soon and start the conversation.
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