IS A PENSION OR 401(k) BETTER FOR YOUR RETIREMENT?
It used to be that retirees could depend on guaranteed lifetime income from Social Security and an employer pension to fund their golden years. 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.
However, there are still some employers that offer pensions to their employees. Pensions are also known as defined-benefit plans. The 401(k) may be the new 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, like 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:
Pensions are more formally known as defined-benefit plans. They’re called defined-benefit plans because the outcome of the plan, or the benefit, is 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. It is then incumbent on the employer to fund the plan to create the promised benefit.
In most cases, pension benefits are guaranteed for life. However, other options may be available. You may be able to take your benefit in a discounted lump sum so you get all the money available. Another option could be to take a reduced annual 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. Your income could be flat, which may be problematic as inflation increases your spending over time.
Also, keep in mind that 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. Even if you have a pension, you may also want to accumulate other retirement assets.
The 401(k) plan is known as a defined-contribution plan, which means the contribution, rather than the benefit, is certain. 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.
3. HYBRID STRATEGY
You could work with your financial professional to take advantage of aspects of both plans.
For example, you could use a 401(k) to accumulate assets, but then use a different vehicle to generate *guaranteed lifetime income.
For instance, 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.
*Guarantees, including optional benefits, are backed by the claims-paying ability of the issuer, and may contain limitations, including surrender charges, which may affect policy values.
This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for, accounting, legal, tax or investment advice.
Colorado Transitions Financial Services Expert
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Frank Oliver is the president and founder of Oliver Asset Management, a boutique firm providing customized strategies for retirement income.
Oliver Asset Management specializes in helping retirees and those transitioning into retirement reduce tax burdens and increase income using the four pillars of financial success:
1. Income Planning
2. Tax Planning
3. Asset Protection
4. Legacy Planning