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It seems many financial terms are known by shorthand that does not readily describe their purpose – 401(k), 403(b), SEPs, PSPs and MPPPs, for example. On the other hand, a term such as “pension” seems easy to grasp but can include the above types of retirement plans or describe a distinct type of plan. When we meet with our estate planning clients, we need to drill down on these types of questions so that we can understand what our clients own and make sure we develop the best approach for wealth accumulation and preservation. Here, we provide an overview of the similarities and differences among pensions, 401(k) plans and 403(b) plans to clarify the various ways retirement plans are structured and how employees can benefit.
Pensions, 401(k) plans and 403(b) plans are all employer retirement plans that allow an employee to receive some form of financial benefit when they retire. A pension can describe a range of different types of plans, but most people think of a pension as a “defined benefit plan”. In a defined benefit plan, an employer sets aside a certain amount of money for an employee on a regular basis. Essentially, the employer defers paying the employee a greater amount in wages while the employee is working in exchange for the promise of regular payments of benefits when the employee retires. The amount of the promised benefit is usually tied to time of service with the employer and the employee’s salary and is paid out over a period of years during retirement in the form of an annuity. These types of plans are increasingly unusual in the private sector, but many public sector jobs and some unionized employees continue to participate in these types of plans.
Traditional pension plans place the risk of underfunding or underperforming investments on the employer. Because of the promised stream of retirement benefits over the retired employee’s lifetime, employees who live a long life after retirement benefit more than those who die soon after retirement. Of course, some of these plans allow for the election of survivor benefits, in which the retiree can choose to take a reduced benefit during retirement in exchange for a continuing stream of payments to their spouse or designated beneficiary if the retiree dies before that spouse or designated beneficiary.
401(k) & 403(b) Plans
401(k) plans and 403(b) plans are very similar to each other. The main distinctions between these plans is that 403(b) plans are available to nonprofits and government institutions, while 401(k) plans are used by for-profit companies. Both of these plans allow employees to voluntarily defer a portion of wages from their paychecks. This deferred compensation is placed in an account earmarked for each employee, grows tax-free and usually allows the employee to invest in a range of investment options. Some plans also provide that an employer will “match” a percentage of the employee’s contributions, which further leverages the employee’s ability to save for retirement. Both of these plans place the risk of investment performance on the employee – poor investment performance can lead to a significant reduction in funds available at retirement. Further, employees can outlive what they have saved if they live a long life after retirement
Employees who withdraw funds from their 401(k) plan or a 403(b) plan prior to turning 59.5 generally incur a penalty on the withdrawal. Employees may, however, take loans from both types of plans. Both plans also require that employees start taking withdraws from their plans the year after they reach 70.5 years of age.
Employees may defer up to $18,500 in compensation annually in either a 401(k) or 403(b) plan. Further, employees who are age 50 years or older can defer an additional $6,000 per year. A distinction between the two types of plans is that some 403(b) plans allow for an additional $3,000 in annual deferrals for those who have at least 15 years of service.
In sum, traditional defined benefit pension plans provide a pre-set lifetime benefit for their retirees while 401(k) and 403(b) plans put the onus on employees to save enough for retirement. If an employee is a careful saver, however, the 401(k) or 403(b) can offer more benefits than those available in the traditional pension plan. Whether you are considering moving to a new job or just embarking on your career, it is important to understand the type of retirement benefits offered by your potential employer. If you are the type of person who enjoys the fresh challenge of frequent career moves, it is unlikely that you will stay long enough at any one employer to benefit from a traditional pension based on years of service. You will need to take individual responsibility to save enough for retirement. For others, a career path offering less in terms of salary might provide for a guaranteed pension benefit that makes up for lower earnings while working. While traditional defined pension benefit plans are in decline, such plans and other hybrids that combine aspects of a pension plan with a 401(k) may be available and are worth investigating.