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March 21, 2006
Making the Move from a Traditional Pension to a 401(k): Overcoming the Gap in Retirement Benefits
As the pension freeze trend continues, more and more workers are finding themselves in defined contribution retirement plans like 401(k) or profit sharing plans, some with employer matching schemes and some not.
One of the most important questions for these workers is how to make sure when making this transition not to inadvertently reduce the amount of pension they will receive when they retire. Or put more simply, how much money does an employee in a defined contribution plan need to save in order to match the amount of money he or she would have received under the old formulas associated with the traditional benefit plans?
The answer might surprise you, but at least one study has estimated that in order for newly minted, mid-career 401(k) account holders to keep the same payments they would have had with their previous traditional pensions, they might have to contribute upwards to 20% of their current income.
Not only might this be practically difficult for most workers to do (even considering a 10% employee contribution with an equal employer match), but there are also tax qualification rules for such plans under the Internal Revenue Code which might make such type of monumental savings difficult to impossible to achieve.
All this point to the fact that mid-career workers might have an especially difficult time maintaining the levels of their retirement funds in this pension freeze environment.
PS
March 21, 2006 in Pension and Benefits | Permalink
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Comments
This is not news! The main reason why companies are switching from defined benefit to defined contribution is not to shift the burden of risk/volatility to employees, as most commentators say; after all, there are plenty of studies that show that for large diversified investors like pension funds that is not a big issue.
The main reason is to mask a reduction in benefit contributions from around 20% to around 5% of salary, and this has been reported several times before.
What the study above says is simply that as companies reduce contributions employees have to make up for it, in other words the switch to define contribution plans masks a large cut in compensation.
Posted by: Blissex | Mar 21, 2006 12:37:35 PM
Of course, employers switching from defined benefit to defined contribution plans are cutting their maximum expenses, but they are cutting their actual expenses even more. I've worked for several employers over the years with 401(k)s. Although the exact terms of the match have varied a bit, they have all matched some portion of the contributions. The best I ever had was a 100% match on the first 4% of my salary I contributed. However, they can be sure that some employees won't take advantage of that match thereby passing up part of their compensation package.
I never pass it up. I've made this recommendation to all of my family and friends: First, contribute to your 401(k) up to the limit of your employer's match. Even if you are only getting a 10% match, it is a guaranteed 10% return on your investment. The only time you get a better return with a guarantee is paying off a high interest loan. That's the second place I tell them to put money. Third is a Roth IRA up to the limit. After that, fill up your 401(k) if you can, but don't forget to put aside some investments and savings outside of retirement accounts that you can tap for expenses along the way.
Posted by: Anonymous | Mar 27, 2006 2:49:09 PM
