All retirement plans are not created equal. In fact, they can be quite different. So it’s important to understand which type of plan your employer is offering, and what you can expect from it — now, and when you retire.
To begin with, retirement plans come in two main varieties: defined benefit plans and defined contribution plans. If you’re particularly lucky, you may be able to participate in both types of plans, but it’s more likely that your employer offers one or the other. Let’s see what you can expect from each of them.
If you have a 401(k) plan — or a 403(b) plan if you’re a teacher or a 457 plan if you’re a state or municipal employee—you’re contributing to a defined contribution plan. In this arrangement, you choose to defer some of your salary, which you then spread among the available investment options. Your money grows on a tax-deferred basis until you start making withdrawals, usually at retirement.
To some extent, your defined contribution plan lets you control your own destiny. You pick the investments that match your goals and tolerance for risk. If you do a good job, you’ll accumulate a substantial amount of money to help pay for your retirement. But this freedom to invest also can work against you. If you make poor choices, or if you don’t properly diversify your retirement plan portfolio, you may be disappointed when it’s time to start taking money out.
The situation is considerably different in a defined benefit plan, such as a pension plan. If you participate in this type of plan, you’ll receive, upon retirement, a specific amount of money based on your salary history and years of service. In many defined benefit plans, should you leave before retirement age, you will not receive any benefit, or you will receive a reduced amount that you can’t touch until retirement age. Many of these plans don’t allow lump sum distributions, so you will receive a set monthly amount in your retirement.
With a defined benefit plan, you have to depend on your employer to make the right moves on your behalf. But that may not be as unsettling as it sounds, because companies that fund pension plans have traditionally based their contributions on a fairly conservative formula that has been pegged to the yield on U.S. Treasury bonds. A watchdog agency, the Pension Benefit Guaranty Corporation (PBGC), also ensures that pensions are adequately funded.
However, in the past couple of years, as yields on Treasuries have plunged, plan sponsors have been required to set aside much more of their own money to meet their pension obligations. This predicament could eventually lead to cost-cutting measures, including benefit reductions, freezes or plan terminations. To ward off this problem, business lobbyists have asked Congress to liberalize the rules governing pension contributions.
As you can see, there are no “sure things” in either a defined contribution plan or a defined benefit plan. That’s why you need to make well-informed decisions. Also, don’t count on any one plan — defined contribution or defined benefit — to fund your retirement entirely. Instead, build up your other savings and investments. The more you put in today, the better off you’re likely to be tomorrow.
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