Despite the fact that pension plans are rarer today than they were in the past, pensions persist as a cornerstone of many individual’s retirement benefits. Understanding how pension funds fit into a retirement portfolio, how they differ from other retirement accounts like a 401(k), and the best way to utilize a pension to maximize your retirement portfolio, are key questions that many eligible participants in pension plans need to consider.
What is the Difference Between a 401(k) and a Pension Plan?
There are significant differences between a pension and a 401(k). Pensions are known as a defined benefit plan. Under a defined benefit plan the employee receives monthly monetary compensation from their employer once they retire. This benefit is typically based on a calculation that takes into account the number of years of service the employee provided as well as their wages earned.
In contrast to a pension plan, a 401(k) is known as a defined-contribution plan. Under a defined-contribution plan, the employee, employer, or both contribute to the employee’s defined contribution account. Under a 401(k), the employee can place a limited amount of their pre-tax income into their account. Employers may match these contributions. The current contribution limit for a 401(k) account is $18,500 per year, or $24,500 if you are over the age of 50 due to the catch-up contribution provision.
The most significant difference between these two types of retirement plans is that a pension provides a defined monthly benefit for the employee for the rest of their life after they retire. In contrast to this, an employee with a 401(k) only receives the amount of money left in their 401(k) account at the time of retirement. Another difference is that a 401(k) account can be influenced by market conditions, while a pension provides a static benefit regardless of market conditions.
The Disappearing Pension Plan
Pension plans have largely been eliminated from the private sector as one of the options for retirement benefits. The responsibility of saving for retirement has been shifted from the employer to the employee. Most pension plans today are offered by public sector employers, with only 5% of private sector employers still relying on defined benefit plans. One of the largest examples is the Federal Employees Retirement System (FERS), which covers federal civilian employees who were hired after January 1st, 1987. Many local and municipal government entities also offer pensions, such as the San Diego County Employees Retirement Association (SDCERA).
Factors to Consider With Pension Plans
The employer has the responsibility of choosing how a pension plan is invested, not the employee. This liability is coupled with the fact the eligible employees are guaranteed a certain benefit once they retire. The issue with this is that it is a liability that many companies are required to honor. Many public pension funds are underfunded, creating a worrisome situation for eligible employees. While not all pension funds face this issue, it is still worth considering when creating a retirement plan.
In order to maximize the benefit of your pension funds, it is necessary to consider some key factors that may influence the health of your retirement. Among these are which annuity option you should choose, whether you should take a lump sum payout at retirement, and how interest rates impact that lump sum payout.
How Do Interest Rates Impact Lump Sum Payments?
There are two main factors that are calculated when a lump-sum payment is made from a pension fund. The first is the total amount that the plan would have paid you over the projected remainder of your life. The second factor is the earnings the plan would have accrued over that time period given prevailing interest rates. The result is that if interest rates are high your lump sum payout will be lower.
Ultimately, how you navigate retirement with a pension plan varies depending on your unique situation. In some cases, the security provided by a fixed payout option outweighs the risks that impact that inflation will have on your post-retirement income. In other cases, a lump sum payout can offer the opportunity to outpace inflation and maintain a higher revenue stream throughout retirement. Whether you decide to stick with a fixed payout option or choose the lump sum payout, it is strongly advised to consult with a fiduciary advisor to determine your best course of action.