My Retirement Blog

In all the discussion about retirement plans, pensions, 401(k)s, IRAs, you may have heard the term “defined-benefit” and “defined-contribution” plan thrown around and wondered what they meant. Both are employer-sponsored retirement plan types but have slight different characteristics.

Defined-Benefit Plan
A defined benefit plan, often called a “qualified benefit plan” or “non-qualified benefit plan,” is an employer sponsored retirement plan where an employee’s benefits are calculated based on an equation using employee factors, such as one’s salary history and length of employment. Under these plans, all the management functions of the plan are handled by the company and they alone bear the risk of their decisions; employees simply get paid out according to the schedule of the agreement.

(In the case of qualified benefit plans, the qualified refer to tax-qualified and the difference is that those plans have added tax incentives. Non-qualified benefit plans do not get these tax incentives)

Pensions are a common form of defined-benefit plan. Many pension equations include a growth rate tied to the results of the investments decisions made by the plan, but if the decisions result in negative results you will often see companies dip into earnings to fund pension shortfalls.

Defined-Contribution Plan
Whereas a defined benefit plan defines the benefit an employee receives, through a calculated equation, a defined-contribution plan only defines the front side of that equation. It’s an employer sponsored plan in which a specified amount or percentage is set aside for an employee. In these plans, the investment decisions may or may not rest in the hands of employees.

401(k) and 403(b) plans are common forms of defined-contribution plan. With a 401(k), your employer agrees to match your contributions up to a certain amount or simply contribute a percentage of your salary each year. In the case of many 401(k)s and 403(b)s, investment decisions and risks are for the employee to make and bear.

When you retire and are eligible to withdraw from your company’s pension, you’re often two options. The first is keep the pension as an annuity and receive payments each month that you and, if you have a spouse, your spouse will receive for as long as you both are alive, it’s called a joint-and-survivor annuity. The other option is to take the amount out as a lump sum and move it to an IRA. There are benefits and drawbacks to both options.

Annuity
The main benefit is that you cannot outlive the annuity, it’s guaranteed payments for as long as you live and something you can depend on. The drawback is that if you reach an early end, any value still left in the annuity cannot be passed onto your heirs.

Lump Sum
Here, the benefit is that if you do reach an early end, you can pass on the value of the IRA to your heirs but the risk is that you outlive the funds inside the IRA.

So, that’s the tradeoff… and there’s a good chance you’ll live a very long time.

More and more companies are doing what Goodyear recently announced that they would do, freeze pensions and move towards 401k’s as the standard retirement vehicle for most workers. Pensions, in general, are very expensive, as you may have surmised by the numbers Goodyear has put out for how much they would save, and employers are moving away from them in droves lately. How much is Goodyear going to save?

The changes will be phased in over a two-year period, and Goodyear indicated that it expects to reap savings of $80 million to $90 million in 2007; $100 million to $110 million in 2008; and $80 million to $90 million in 2009 and beyond.

Honestly, I think this is better for most workers because pensions depend on the solvency of the company that offers them. Sure, the company is supposed to fund the pension so that even if they go bankrupt, the pensions would survive - but as recent airline bankruptcies have shown us, this isn’t a certainty. The Pension Benefit Guaranty Corporation (PBGC) paid out pennies on the dollar when some airlines went under! So by moving away from pensions, employees are better off from a responsibility perspective because they don’t believe that the freebie will be there in the future. Obviously, by removing pensions all together, it’s a losing proposition for employees but at least there’s a philosophical silver lining.

Ultimately, it’s is better to not be reliant on something like a pension because it can certainly vanish into thin air (or be converted into pennies) even though employees are losing in the long run.

When it comes time to cash out your retirement, it usually comes down to a decision of whether you want to take a lump sum or income for life (or a mix of both). Here are some reasons why you should consider a lump sum.

1. You can control your investments

If you take the lump sum, you can turn around and invest that money on your own. You get to make the decisions and you’re in the driver’s seat, this of course could be a good or a bad thing!

2. You aren’t afraid of inflation

When you take a lump sum and are able to invest that money, you can protect yourself from inflation. When you take income for life, the income may not be adjusted for inflation (in fact, very few are) so your check loses buying power year after year.

3. Bird in the hand…
When all those airlines went bankrupt, the first to go was the pension… income for life may mean income for the rest of your life or income for the rest of your company’s life, whichever is shorter. If you company goes under, the Pension Benefit Guaranty Corporation, which insures pension plans, only pays out pennies on the dollar.

Just like finding lost money owed to you (say, from a security deposit on an apartment), lots of folks have pension benefits that they don’t know about or have lost track of! Personally, I know I don’t have pension benefits because I wasn’t at my first job long enough and my current one doesn’t offer a pension but it’s easy to lose track when you move around often, forget to leave forwarding addresses, and, surprisingly, get married and change your name. In a Bankrate.com article, Pension Benefit Guaranty Corp. (PBGC, the same one that bails out bankrupt pension plans for pennies on the dollar) reported that the average lost account was worth over $5000 with the highest lost pension over $255k!

If you want to find out if you may have pension benefits floating out there somewhere, the PBGC has a free tool which lets you search “missing pension funds by last name, the name of the company for which the participant worked or by state.” If you can’t find the company, another tool “allows [you] to search by pension plan name, PBGC case number or the company’s name.”