It’s fun for the financial media to poke fun at pension programs, describing the time-worn pension as all but dead.
In truth, about 1 in 4 Fortune 500 employers still offer a pension to newly-hired employees. The pension plan isn’t extinct just yet, but it is less common than it once was and many pension plans being offered now scale back on benefits and sometimes a hybrid solution: a basic pension plan while also encouraging employees to contribute toward their own retirement with 401(k) plans.
What is a pension?
A pension is a guaranteed income for retirement provided by an employer’s pension plan. Pensions are most common among government employers and larger corporations — but used to be common in manufacturing industries as well. Qualified employees receive pensions based on the number of years of service, age, and compensation rates before retirement.
There’s been some concern that existing pension plans could fail, leaving workers who were counting on their pension income to fund their retirement without a complete solution. Pension plan sustainability is indeed a cause for concern, but in many cases, the risk is mitigated by government pension insurance provided by the Pension Benefit Guaranty Corporation (PBGC).
Founded in 1974 as part of the Employee Retirement Income Security Act (ERISA), the PBGC protects pension benefits for employees of private sector employers. If an employer’s pension plan terminates without enough money to pay all the benefits it promised to pensioners, PBGC’s insurance steps in, covering all or part of the pension payments promised by the plan. The PBGC does not cover profit sharing plans, employee stock ownership programs (ESOP), or other defined-contribution plans, such as 401(k)s.
Ways to save on your own
Several other options to fund retirement savings exist that can take the place of a pension or can work in concert with a pension. First, let’s look at some common fixed income solutions.
Social Security retirement benefits
Social Security is an expansive program best known for its retirement benefits. Social Security’s retirement benefits are based on income earned during working years and are subject to eligibility based on the number of years worked. Because there is a cap to Social Security retirement benefits, retirees with lower earnings in their work history see the largest percentage of their income replaced by Social Security. Higher-income workers will find a greater spread between their former wages and the retirement benefits paid by Social Security.
Seniors and retirees are eligible for Social Security benefits beginning at age 62, with mandatory withdrawals beginning at age 70 and benefit amounts increasing by 8% per year between age 62 and age 70.
Guaranteed annuities are another method to supplement or replace pension income. An annuity gives you your own pension with guaranteed payments each month and the option to make your annuity available to surviving spouses or heirs.
The concern many retirees and hopeful retirees have is that they’ll outlive their savings, including CDs, bank accounts, 401(k)s, and other assets saved. The concern is valid, now that we’re living longer and health care costs have increased, which all creates additional concerns about the cost of long-term healthcare.
A guaranteed annuity provides an annual return, typically much higher than CD rates or bank interest rates, based on the amount of money invested in the annuity and the options you choose for your annuity. Annual returns of 7% aren’t unusual but rates can vary. If you’ve been successful in reducing your living expenses and have cash saved or can convert other assets to cash without a penalty, an annuity can be a great way to guarantee income during retirement, much like a pension.
Non-guaranteed retirement investments
401(k) / 403(b)
Employers that don’t provide a pension plan often provide a 401(k) plan instead, or an equivalent plan for government workers, like the 403(b) plans available for school employees. These plans typically offer a handful of investment options, often sorted by risk and usually offered as mutual funds.
This structure gives employees the option to invest their retirement plan according to their risk tolerance and performance goals. In most cases, employers offer matching contributions up to a fixed percentage of your contribution. Because 401(k) and 403(b) plans are tax-deferred, your investments can compound faster — but your withdrawals will be taxable as income when you begin to withdraw and your savings within these plans are subject to penalties if you withdraw funds prior to eligibility age.
Individual Retirement Account
Often providing more independence than a 401(k) plan, an Individual Retirement Account (IRA) can help you to save more for retirement with one of two tax-advantaged options.
A traditional IRA functions similarly to a 401(k), with the notable exception that there are no matching contributions from an employer because an IRA is an individual plan. Traditional IRAs allow you to invest and watch your money grow tax-deferred, subject to similar limitations to those found with a 401(k), such as early withdrawal penalties. These plans are designed for retirement savings, and while your money is available to you at any time, accessing your money before you reach eligibility age will include a 10% penalty on the amount withdrawn.
Roth IRAs function differently, with all contributions to a Roth taxable at the time you make your contribution but with withdrawals being tax-free, assuming you’ve reached eligibility age. It’s not uncommon for retirement savers to have both a traditional IRA and a Roth IRA, or for 401(k) plans to be rolled over into one of these options when workers change jobs or are between jobs.
Individual Investment Accounts
Individual investment accounts provide more freedom to participate in the market recovery and future growth by providing more investment options than are typically available with retirement plans like 401(k)s and IRAs.
Unlike their retirement-focused brethren, 401(k) and IRAs, individual investment accounts aren’t tax-advantaged, but the additional freedom to invest in any stock, ETF, or mutual fund makes individual investment accounts worth a second look. Many mutual funds and brokerages offer the opportunity to make automatic investment contributions according to a schedule that you set, which puts the magic of dollar cost averaging to work and builds your investment savings for retirement or any other purpose.
Pensions can be part of retirement planning, but are becoming more scarce as fewer employers offer the option. When pensions aren’t available or need to be supplemented, a number of options can help you reach your retirement planning goals through a combination of savings and guaranteed income. Whether retirement is still a far away dream or you’ve already arrived, there are likely some ways to improve your financial position to help ensure that your worry-free retirement remains worry-free.