Monday, September 8, 2008

What Disappearing Pensions Mean To You

I remember as a kid hearing older relatives talk about getting their pension as in "Uncle Bob worked for them 35 years and now gets half his salary for the rest of his life". For better or worse, those traditional "pensions" are slowly fading into history. These "pensions" are plans where your benefit is determined by a formula and guaranteed for life. As people live longer, these plans are becoming more expensive for companies to provide. They also have downsides such as the requirement you must work for the same company for 35 years. It is just not terribly common to be a "company man" anymore. In addition, what are the odds that the company you start out in is going to survive and prosper in what becomes a mature industry 35 years later?

Over the past three decades or so, defined contribution plans have come to replace defined benefit plans, the latter being those described above where the company is responsible for guaranteeing the plan's results. Defined contribution (401K's) plans differ in that the contribution is made today, meeting the company's obligation in the present, rather than guaranteeing the results decades later. Defined contribution plans are also portable in that an employee earns their benefit as they go and can take the account with them when they separate from service by retirement, layoff, or career change.

Naturally, 401K's have certain downsides, most importantly that the ultimate results of the plan are not guaranteed and are largely unpredictable. For example, the 401K should be invested so that the contributions grow, right? Stocks or bonds? What will this be worth when I retire? How much can I take out? Many uninterested and uninformed employees must now be making decisions they are not qualified to make, the consequences of which enormously impacts retirement.

A common misunderstanding regarding 401K's goes something like this: "Well they don't have the pension anymore, so why should I save in their 401 plan when I can just save on my own?" This is faulty in several respects not the least of which 401K's must entitle you to what I call "free money". All plan sponsors must contribute to the plan if the employee does. How much is plan specific, but the typical minimum is 2 or 3% of the employee's earnings, often 6% or more.

The other problem with this thinking is that "saving on your own" does not have a tax break. The tax break is two-fold: you get a deduction for the money you put into the 401K and you don't pay taxes on the income until the money comes out. A tax break today in the form of a deduction is an obvious benefit, but the deferred taxes on gains is equally generous. Let's say you earn 10% each year, but have to pay taxes of 30%. This means that you are compounding at 7% each year instead of 10%, affecting the ultimate benefit dramatically. In this example, $10,000 would turn into $76,123 at 7% for 30 years or $174,494 at 10%- over double the benefit.

"But, I can use an IRA to save on my own..." you say. Perhaps, I say. Find out more in a post coming soon to a blog near you.

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