Comparison of a Defined Pension Plan Vs. Contribution Rate Into 401ks
Only a few decades ago, the defined benefit pension plan was the standard for both employees and employers. Under this type of plan, employees who put in a minimum number of years for an employer could expect to receive a monthly pension check upon retirement for the rest of their life. Today those defined benefit pension plans have largely been replaced with defined contribution plans like the 401k. These plans provide less certainty, but when invested wisely, they can provide superior benefits.
Other People Are Reading
-
Mobile Workforce
-
One of the original arguments in favor of defined contribution plans like the 401k was that the modern workforce is much more mobile than the workforce of previous generations. While workers in past generations often remained with the same company for 30 years or longer, the average tenure of modern workers is much shorter. Defined contribution plans provide a retirement fund that workers can take with them when they go to another job, as opposed to a pension plan that would be forfeited if the worker left the firm before becoming vested in the plan.
No Guarantee
-
Perhaps the biggest downside of defined contribution plans like a 401k is that the money is not guaranteed. Investors who participate in a 401k typically have access to a number of investment choices, including stock mutual funds, bond mutual funds and international funds. If the value of those funds rises over time, investors can save quite a bit of money. But if those investments fall, workers can retire with much less than they would have had in a traditional pension plan. In addition, it is up to the worker, not the company, to decide how best to withdraw that money in retirement. Making sure the money accumulated in a 401k lasts throughout retirement can be a huge challenge.
-
Earnings Potential
-
One potential advantage of a defined contribution plan like a 401k is that they can have a higher earnings potential if invested wisely. For example, a 25-year-old worker who makes $40,000 per year and contributes 10 percent of his salary to a 401k plan for 40 years would retire with a nest egg worth more than $1.4 million, assuming a reasonable rate of return of 8 percent and a standard 50 percent employer match on the first 6 percent of contributions. Withdrawing a conservative 4 percent of that $1.4 million nest egg in retirement would yield an annual income of $56,000 a year, more than many traditional pension plans.
Annuity Option
-
Investors who have a defined contribution 401k plan but want the security and steady paycheck of a defined benefit pension plan can consider using their 401k proceeds to purchase an immediate annuity. An immediate annuity turns a lump sum of money into a series of monthly, quarterly or annual payments, mimicking the effect of a traditional pension plan. The payout on an immediate annuity depends on a number of factors, including the age and life expectancy of the buyer.
-
References
- Photo Credit cash image by Alexey Klementiev from Fotolia.com
