When it comes to retirement plans offered by employers, workers have three main options, depending on where they work: 401(k) or 403(b) plans or an employer-funded pension plan.
Of the three, pension plans are becoming the rarest option. And which plan you can use depends entirely on where you work and what your company offers.
But what are the differences between these plans, and what are the pros and cons of each? Let’s take a quick look at how each of these retirement options work and what they offer employees.
401(k), 403(b) Plans Share the Most Similarities
Kevin Michels, a financial planner with Draper, Utah-based Medicus Wealth Planning, said that of the three retirement savings vehicles, 401(k) and 403(b) plans share more similarities than they have differences.
As Michels says, both 401(k) and 403(b) plans provide tax benefits for employees who save and invest money for retirement. Both plans also require employees to determine how much to invest from each paycheck and how to invest these dollars.
In other words, the work of saving for retirement is the responsibility of employees, not the employer.
“Both plans place the burden of investment choice and risk on the employee, sometimes with the help of a financial advisor,” Michels said.
Under both plans, employees contribute a portion of each of their paychecks to a retirement savings account. The hope is that these contributions will grow over time according to the performance of the stock market. Employees can usually choose which mutual funds to invest their contributions in, with many starting their careers by investing in funds that carry higher risks but the potential of greater financial rewards and then switching to lower-risk funds as they get closer to retirement.
Both 401(k) and 403(b) plans are what are known as defined-contribution plans. The main difference between the plans lies in which employers offer each: 401(k) plans are offered by private, for-profit companies; 403(b) plans are designed for certain employees of public schools and those working for tax-exempt, non-profit organizations.
In both plans, employees can contribute a maximum of $18,500 per year until they turn 50. Once employees are older than 50, they can contribute a maximum of $24,500 per year in these plans.
The biggest difference between these two retirement-savings plans is that 403(b) plans do not offer the profit-sharing opportunities that come with 401(k) plans. This is because 403(b) plans are offered by non-profit and government employers that don’t have those extra profits to share with their workers.
Jason Speciner, certified financial planner and founder of Financial Planning Fort Collins in Fort Collins, Colorado, said that some 403(b) plans provide an additional benefit for employees who have worked on their jobs for a long period of time. These employees can contribute an additional $3,000 each year to their plans if they’ve been employed for 15 years or more, Speciner said.
The Rarity of Pension Plans
Pension plans are a different sort of retirement-savings vehicle – one that most employers today no longer offer. As Michels says, a pension is funded solely by employers; employees do not have to contribute a portion of their paychecks to fund a pension.
Michels says that employers credit their workers with a certain monetary benefit each year, an amount usually based on workers’ compensation levels and years on the job. When these workers retire, their former employers provide them with these pension dollars each year.
Pension plans, then, are the gold standard of employer-provided retirement funds. Unfortunately, pensions are becoming rarities.
“Because of the cost and risk associated with pension plans, most employers are moving toward 401(k) and 403(b) plans,” Michels said.
The reason for this is obvious: Employees contribute the majority of funds in 401(k) and 403(b) plans. Pension plans, also known as defined-benefit plans, require employers to make the retirement contributions. They, then, are far costlier options for companies.
Clifford Caplan, founder and president of Norwood, Massachusetts-based Neponset Valley Financial Partners, said that when he entered the financial-planning industry four decades ago, most profitable companies provided a defined-benefit pension to employees.
Those days are long gone now, with many of these companies terminating their plans, allowing participants to either retire early with their pension or roll over the value of their account into an IRA.
In place of pensions? These companies now offer 401(k) plans, Caplan said.
Today, pension plans are most commonly offered by governments. These plans, though, face their own challenges and risks, Caplan said. And even government bodies today are reworking their pension plans, he said.
“Many of these plans are grossly under-funded, such as in the state of Illinois, and the unfunded pension liability has the potential to create significant financial stress in the future,” Caplan said. “Many government plans have either limited or eliminated defined-benefit plans for newer employees in light of this significant shortage in funding.”
Pros and Cons
Those workers lucky enough to work at a company that still provides pension plans should have an easier time budgeting for their retirement years. Chad Rixse, co-founder of Millennial Wealth in Seattle, says employees receive a guaranteed annual income from their pensions either for life or a specific period of time after they retire.
This doesn’t mean that pensions don’t come with some drawbacks. Rixse points to control: In a 401(k) or 403(b) plan, employees can determine how much of their paycheck they want to contribute to their retirement. They can also make choices on where to invest these dollars, within some limitations.
With a pension plan, though, the employer makes these decisions.
“Employees have little control over how their pension fund is invested,” Rixse said. “Funding requirements for the plan fall mostly on the employer’s shoulders. If the employer has a down year in sales, it still has to meet the pension plan’s funding needs.”
Of course, 403(b) and 401(k) plans come with potential pitfalls, too. Rixse said that these plans only work when employees commit to them. Those employees who put off contributing to these plans early in their careers might find themselves with far too little savings when their retirement days finally arrive.
“Long-term success relies largely on the employee,” Rixse said. “They must adhere to their savings goals to have the income they’ll need in retirement.”
Another potential problem with 401(k) and 403(b) plans? Some charge high fees for participants, Rixse said.
What questions do you have about these plans? Let us know in the comments below.
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