A century ago, the concept of “retirement” didn’t really exist for most of us. We simply would work for as long as we could, in one way or another.
Over time, that dynamic shifted dramatically-due to a complex mix of economic changes, shifting demographics, greater prosperity and longer lifespans-and older Americans increasingly embraced the idea of withdrawing from the workforce as they aged.
Alongside that cultural evolution, an array of retirement savings vehicles emerged in the 20th century to provide retirees with an income in their post-working lives. Pension plans provided by public and private sector employers and the broad-based retirement insurance of Social Security were among those innovations and developments.
Recent decades have brought a new round of innovation with the rise of retirement savings accounts aimed at giving workers greater control over their financial future. The rise of savings vehicles like the Individual Retirement Account (IRA) and 401(k) plans (so named for its designation in the tax code) have further revolutionized the way we approach retirement-for the better.
Understanding Your Retirement Plan
Here are two key terms to understand when it comes to retirement plans: defined benefit and defined contribution. What’s the difference?
- In brief, a defined benefit plan is an investment pool that pays benefits to retired workers based upon factors like years of service to the employer and individual salary levels. Defined benefit plans are tied to a specific employer (or other entity, such as a state or union).Contributions to the pension fund is made by the employer or plan sponsors, with the overall pension plan managed by other parties. Upon retirement, the retiree receives a fixed payment for the rest of their life.
- In contrast, a defined contribution plan is one in which the employee has a dedicated account to which he or she contributes, either on a pre-tax basis or in the case of Roth 401(k)s, a post-tax basis (more below). The employer, which sponsors the plan, will often contribute an amount or match a percentage of the employee’s contributions. Defined contribution plans are tied to the specific employee. The value of the account is dependent upon the level of contributions and investment returns, and the employee usually has some say in how the funds are invested. Upon reaching a certain age, the employee must withdraw a certain dollar amount each year until the account is depleted.
Assumed “gold standard” of retirement plans
Odds are that unless you work in the public sector and/or are a member of a union, you don’t have a defined benefit plan. Your retirement savings are more likely administered through a 401(k)-type plan, or perhaps through an IRA if you’re self-employed.
Some consider the traditional pension the gold standard for retirement benefits. And it’s true those plans have real benefits for those who receive them. Among the potential benefits: pay their relatively secure benefits as an annuity, so retirees do not have the risk of low investment returns on contributions or outliving their retirement income.
But most pension plans require workers to be fully “vested” to be eligible to receive benefits by working for a minimum numbers of years, with benefit levels increasing at a graduated pace, before they’re eligible to receive any benefits.
You can probably recognize one of the most substantial drawbacks to that system: younger and mid-career workers who are employed at a company for a few years are likely to find themselves ineligible for benefits if they should change careers, move to a different firm, or are laid off. If they’re not fully vested in the plan, they may be sacrificing a substantial part of their retirement savings.
Meanwhile, the longer a worker stays in one place accruing vested benefits, the more likely he or she will be “locked in” to that job. That is, they can’t afford to leave because they would be sacrificing a substantial retirement package.
The rise of the personal retirement plan
Today’s retirement landscape is marked by the rapid growth of retirement plans held through defined contribution savings vehicles like 401(k)s and IRAs. Key features of these accounts are:
Portability. Since the 401(k) account is assigned to you personally, the employer contributions usually vest more quickly than in a traditional pension, and you can leave the money where it is, or roll it over into another account. In an age when far fewer Americans are likely to work at a single firm for their entire career, that portability is a significant benefit.
Inheritability. Since you own your plan, you can designate beneficiaries on your account to pass the funds on to family members or friends in the event of your death.
Matching contributions. Most 401(k)-style plans include a contribution or matching component from the employer, which helps to drive more rapid accumulation in the account.
Choice in investments. Most defined contribution plans offer multiple investment options to allow you to build a diversified portfolio. The average 401(k) plan now 401kk