How Pensions Work With Your Financial Plan
Hi everyone, and welcome back to Melissa Making Cents!
As a CERTIFIED FINANCIAL PLANNER™ and financial coach, I understand that retirement isn't something we should put off thinking about. One of my jobs as a financial planner is to get to know you. By getting to know you, I learn what drives you and what your long-term financial goals are. Through that process, I can develop a plan that connects where you currently are to where you'd like to be in the future.
Retirement can be a sensitive subject, and surprisingly for some, it can also be a hot-button. Financial professionals, banks, and employers all have starch ideas of how you should be using your money to invest in retirement. That can be incredibly confusing for someone caught in the middle that may not be the most literate in financial planning. Pensions are one way of planning for retirement that many have strong feelings about, and for good reason if you have seen the bed news stories on them. If you're confused about pensions, don't worry. We're going to take them step by step and talk about what they are, different versions of them, and how they work. We're also going to discuss a little bit of their history. Through all of this, we'll hopefully find an answer as to whether a pension is how you'd like to carry on with your retirement planning or not.
What is a Pension?
Saving and investing in your retirement is crucial, and it's important to start early. Pensions are one of many ways we can begin investing to retire. Pensions are offered by employers, so they're not wholly available for anyone. There are different types of pensions that operate in slightly different ways. Still, a pension is basically an agreement that your employer, or government, will pay you a certain amount of money once you retire.
Examples of Pension Plans Include:
- Social Security
- Government Pension Retirement fund of Japan
- Military Retirement Fund (Although this is Changing)
- Federal Employees Retirement Fund
- Civil Service Retirement Fund
- Teachers Retirement Funds (All states)
With a pension, you contribute a certain amount of your pay every month. Your employer is also required to contribute a mandatory amount to your pension. This usually correlates to a percentage of how much you're contributing. All of this money goes into an account that's available to the employee upon retirement. While the employee is still un-retired and working, the money is invested at the direction of the pension fund manager, in multiple long-term, like mutual funds. The money that is contributed and earned by investing with a pension isn't taxed until it is withdrawn from the pension. This translates into making the most of your invested money. This is where we split with different types of plans. The two main types of pensions are defined benefit and defined contribution pension plans. So, what are the differences?
Often individuals that contribute to a pension plan are subject to a Windfall Elimination Provision that permanently reduces your social security benefit. Read my blog from last week that explains the WEP.
What are Defined Benefit Pension Plans
Defined benefit is "the old way" of doing things when it comes to pensions. These plans require the employer to contribute on behalf of the employee, and are mainly used in public sector jobs, like teaching and civil service. They are (or were) lower risk to the employee because the employee contributed a specific amount of money and was assured of getting a particular return with each payment once they retired. The amount that employees were entitled to under a defined benefit plan relied on the outcome of a formula that used average salary and length of time working for the business to calculate the payout. While these plans are much safer for the employee, they're also much more expensive for the employer. Defined benefit requires an employer to subsidize whatever loss their investments may have taken. Unfortunately, defined benefit plans are being slowly replaced by defined contribution plans because of their cost to employers.
What are Defined Contribution Pension Plans
Defined contribution, which include 401k plans, puts more of the power (and risk) in the hands of the employee. Instead of the company determining the amount or percentage that the individual invests, that is left up to the employee. The employee is also left to choose what to invest in, putting more control in the individual's hands; This results in businesses holding their employees more personally accountable for how their pension plan performs. Employers are not required to subsidize losses that the pension's investments may or may not take as they do with a defined contribution. This also means that an individual can invest more money than they receive with a defined contribution due to the nature of the investments inside the plan. It's important to talk to a financial professional about the available investments to evaluate which fund(s) might fit best into your financial plan.
The Pros and Cons of Investing in a Pension Plan
Don't get scared off just yet; there are good reasons one might invest in a retirement pension plan. Many employers match your investment for starters, and some will even go as far as to match your investment and add a certain amount. For example, if you were to invest $1.00, an employer will also invest $1.00, and some may invest a dollar and fifty cents! Over time, those matched contributions can seriously add up. Not to mention, if you're on a defined benefit plan, then you're guaranteed (basically) free money.
If you begin investing early, then you also have loads of compound interest and earnings to look forward to. If you don't know, compound interest is when your money's returns are reinvested. Over time, the reinvestment creates a snowball effect, and you get to watch your money grow and grow. The third benefit of pensions is that they might have some fantastic tax incentives. (Consult your tax advisor or CPA to talk about these tax benefits) With pensions, your money will go untaxed when contributed and reinvested. (Stay tuned for my blog post next week explaining the magic of dividend reinvestment.) You'll only have to pay taxes on your pension money once you begin drawing it for retirement. While those are some serious benefits, they're even better together. Tax benefits, plus compound interest, plus employer matching all add up to you making the most out of your money… or does it?
Unfortunately, there are also negatives that come with pensions. Obviously, one large negative with pensions is that they can be challenging to wrap your mind around. That's why a lot of you are this deep into this blog post. Employees can often feel that they don't know precisely what they're doing when it comes to pensions. Secondly, with a pension, your funds aren't exactly accessible. Suppose there's an emergency or you're immediately in need of money. In that case, you're going to be unable to access your pension money, or you're going to take a penalty for taking money out early. Lastly, if you're investing in a defined contribution plan, you aren't necessarily assured your money back.
Luckily, there are ways to minimize the negative aspects of a pension plan. Start by educating yourself. Make sure you talk to your HR department and have a clear outline of what your plan is, how it works, and what your risks of investing are. Once you've done that, I'd highly recommend taking that information to a financial planner/financial professional, like myself, to discuss your options and if it's worth it for you to invest in that specific plan. Next, always be sure you have an emergency fund. This will stop you from ever needing to dip into your pension so you can avoid any early-withdraw penalties. Obviously, the most concerning negative associated with pensions is that of risk. What would happen if your money shrank through the investment process? Meeting with a financial professional can help you create a plan and avoid such a scenario.
Why do Pensions Get a Bad Reputation?
Pensions have a sort of rocky history. While many consider them fantastic, others are much more skeptical of the benefits offered by pensions. It's not totally unfounded either; there was a prime example of how pensions can go wrong in 1963 when a famous car manufacturer, Studebaker, went bankrupt. When they did, around 4,500 employees who had been contributing to pensions were left high and dry. Many lost their pensions in their entirety, but most of the 4,500 workers lost around 85% of their contributions. Studebaker was a large and prime example of how pensions could go wrong, but they weren't the only ones. On a much smaller scale, occurrences like these were happening all across America. Using Studebaker as an example, American citizens demanded change. Almost ten years after Studebaker's events, Gerald Ford signed ERISA, or the Employee Retirement Income Security Act. ERISA also created an institution called PBGC, or the Pension Benefits Guaranty Corporation. In coalition, ERISA and PBGC were established to protect American pensions should their business fail.
While the PBGC does protect Americans, it is also not safe from insolvency. The PBGC operates by charging a premium for businesses to protect their employee's pensions. It uses the money charged for insuring others. Unfortunately, membership in the PBGC is on the decline. At its peak, PBGC certified 30% of all American pensions. Currently, that number is closer to 22%. The PBGC is also operating at a 50 billion dollar deficit and is at risk of being insolvent by 2026.
Alternative Options for Your Retirement Planning
Because there are significant risks involved with defined contribution pensions, if that is the option you're given by your employer, you should talk to a financial professional. Find out if that's really the best option for you and your retirement investment or if there is perhaps another way forward. You may also have the option to invest in multiple retirement options, all of which have their own unique sets of pros and cons. Outside of pensions, here are a few types of retirement plans.
Social Security. Social security is a governmental pension program that was passed by Franklin D Roosevelt in 1935. About nine out of ten Americans receive social security once they reach the age of 65 or older. Unfortunately, the average benefit to individuals has gone down as the taxes funding social security have gone up because of population changes. While social security is one option, younger generations should likely have other backup plans.
Individual Retirement Accounts (IRAs). IRAs are another government-created program. IRAs are owned by individuals and can be set up by most financial institutions to hold investments. One of the pros of IRAs is that they come with tax benefits/deferments. There are two main types of IRAs: Traditional and Roth. Traditional IRAs are tax-deductible and aren't taxed until you withdraw them, while Roth IRAs are tax-free. If you withdraw before 65, you'll be charged a penalty and tax on a Roth.
There are tons of other retirement options outside of Pensions, Social Security, and Individual Retirement Accounts. There are multiple types of Defined Contribution plans, IRA plans, and the like that I didn't cover simply for time purposes. There are also Guaranteed Income Annuity (GIAs) Plans, Cash-balance Plans, and Nonqualified Deferred Compensation Plans (NQDC). Because there are so many options for saving and investing for retirement, the best course of action is to consult a CERTIFIED FINANCIAL PLANNER™, like myself, who has background knowledge in finance and can help you choose the plan/plans that will fit you and your lifestyle.
A CERTIFIED FINANCIAL PLANNER™ Can Help Answer Questions About Pensions and Retirement Planning
Pensions can be confusing; they're also not for everyone. Different types of pensions, like defined contribution and defined benefit, operate in different ways. With Defined Benefit, you have less control over how your money is invested, but you're guaranteed that money back when it comes time to retire. With Defined Contribution, you get more of a say in where your money is invested, but you're on the hook for how it performs. There are pros and cons of pensions, too. Pensions have tax benefits, most businesses match your contribution, and if you start early, you get the added benefit of compound interest.
The most important thing to remember is that everyone is unique, and their financial plans need to reflect their uniqueness. Are you interested in finding out what the best type of retirement plan is for you? If you'd like help sorting through all of the options for investing and creating a safety net for retirement, or if you'd like to learn more about pensions, please call or email to schedule an appointment with me. I'll work with you to create a financial plan and retirement plan that is built to work in your favor.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox CERTIFIED FINANCIAL PLANNER™ is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.