I can feel the full force of the holiday season. I see lots of decorations, people out partying, and the stores packed with shoppers looking for gifts. In addition to holiday festivities, around this time people start their end of the year financial housekeeping in order to start the New Year off right.
As I mentioned before, my firm decided to switch 401k companies. Consequently, we have worked diligently to make sure we have everything straightened away to begin the new plan in January. This transition and talking with my coworkers about our new plan opened my eyes to the lack of basic understanding about retirement plans. Several of my coworkers weren’t aware of the contribution limits, the differences between the types of plans that were offered, or how the employer match worked.
So I wanted to take time this week to go over some retirement plan fundamentals to help you better understand your retirement plan system.
Defined Benefit vs. Defined Contribution Plans: The reason we have retirement plans at all.
When I was growing up, I would hear my dad talk a lot about his company – General Motors. It was a time where he and his colleagues worked for the same company for the majority, if not all, of their career. The company rewarded this tenure and service with a pension plan. The pension plan promised to pay a specific amount of money when he retired based on his earnings, time spent at the company, and age. He would receive this amount for the rest of his life.
To me, this setup sounded like a great deal. These plans, known as defined benefit plans, gave you steady income that you could count on in retirement. Or at least you thought you could count on. As most of you now know, GM went through a dismal period during the recession and almost collapsed. My mom, who receives my dad’s pension since he died before retiring, was terrified it would be lost or cut. She luckily didn’t suffer any reduction in her benefit amount. But several people we know did.
That economic crisis and the current budget shortfalls with state and municipal governments (e.g., Detroit, Chicago, etc.) highlight a serious problem with a pension system. Employers find it harder and harder to cover the costs of pension plans. And the employees could lose a portion of their benefit, if the employer can’t meet the expense.
Because of the problems with funding and costs associated with paying these pensions, many companies have switched to defined contribution retirement plans. These plans – 401k, 403b, 457, TSP plans – require the employer and employee to contribute a defined amount, and upon retirement the employee uses that money to cover his or her living expenses.
The switch from the defined benefit plans to defined contribution plans has transferred the burden of funding retirement from the employer to the employee. In short, the employer no longer has to worry about putting away money and investing it to make sure it can pay pension benefits. Instead, the employee has to make sure that his or her retirement accounts plus and other outside sources (e.g., social security, investments, trusts, etc.) will meet his or her retirement needs.
Since the burden now rests with you as the employee or as a self-employed person, it’s more important than ever to understand the ins and outs of your plans and make sure you do all that you can to ensure a comfortable retirement. I’ll delve deeper into the specific types of defined contribution plans tomorrow.