February 2, 2020
Photo by Unsplash
Just about every full-time job now (and many contract gigs) will include a retirement plan as an employee benefit. You should know the basics, as these can be valuable perks. At the very least, retirement plans offer tax credits and deferrals, hassle-free investments, and automatic payroll deductions. If you’re fortunate, your employer may offer a profit-sharing feature, match your contribution, or even provide a full pension plan, all of which involve additional money the company gives to you under certain conditions. These can be meaningful benefits, require little effort on your part to participate, and could be of significant value to you over time. What’s more, most of these benefits become yours to keep, regardless of how long you stay with the same employer.
The two main types of employee retirement plans in a nutshell:
They are the top-of-the-line retirement benefit. They are defined benefit plans, meaning that participants are promised a specific benefit when they retire. Teachers, municipal workers, and government employees often have plans like these, but they are few and far between in the corporate world.
For pension plan recipients, the benefit could approach 75-85% of pre-retirement income…paid each year for life!The employer guarantees the benefit and takes the responsibility for managing the investments. The magnitude of a pension benefit can be striking. A person who retires at age 65 with $75,000 a year for life could easily realize a benefit of $2 million or more during their lifetime.
Most employers have now adopted defined contribution plans – namely the 401(k). These plans are far less expensive to the employer than pension plans (since the contributions come from you) and with defined contribution plans employers are completely off the hook to pay an employee benefit when you retire. Instead, they have effectively shifted the retirement responsibility en masse to the employees.
That means your need to save for retirement (and manage the investment) squarely rests on you! Companies can make profit-sharing contributions to your 401(k) account or they can match your contribution up to a maximum of 6%, but both of these features are optional. Importantly, if there is profit-sharing, it goes to all qualified employees, but the match only goes to those who contribute their own money as well. That’s why it becomes very compelling to make a large enough contribution on your own to qualify for a match if your employer provides one. (Employee matches are well publicized commitments, so it is easy to determine if your plan has one and how to qualify for it.) If you do qualify, the match is an outright gift from your employer and everyone should take advantage of it if they can.
Contributions to a 401(k)plan are pre-tax. That means you get to deduct your annual contribution from your taxes, and no gains are taxed until you withdraw your money many years later. There are, however, limits to both your own and your employer’s contributions.
For 2020, the max contributions you can make are:$19,500 if you are under 50 years of age; and $26,000 if you are 50 or older. (These limits are separate from any matching or profit-sharing contributions by the employer.)
Importantly, 401(k) money is yours and stays with you. If you leave the company, you can roll it into your new company’s plan or into your own IRA. If you come to an untimely end,it goes to your beneficiaries. Even creditors cannot get at your IRA money. And if you really get into dire straits, you can stop or suspend your contributions, or even withdraw funds for a hardship or to buy your first home.
Note: All 401 (k) plans are similar but not identical. They follow certain universal rules, such as contribution limits, but each employer (plan sponsor) can customize their plan as to eligibility, match, choice of investments, etc.)
Other less common plans are available to sole proprietors, small companies, executives, non-profits, and public employees. These include:
Employee Stock Ownership Plans (ESOPs)
SEP and SIMPLE plans
403b and 457 plans
If you have access to one of these, contact us for more information.
Frankly, you owe it to your future self to sock away as much as you reasonably can for your non-working years. If you have a 401(k) at your disposal, you’ll get to do that with at least a little help from Uncle Sam on your taxes. How much you should put away will vary quite a bit depending on your age, number of years to work, expected life span, and annual returns on investment. As a rough benchmark, the Stanford Longevity Center compared numbers from retirement plan providers and suggested that “Americans planning to retire at age 65 need to put aside 10 to 17 percent of their income for retirement preparation, even if they start saving as early as age 25.If they don’t start saving until age 35 but still wish to retire at 65,then they need to contribute 15 to 20 percent of their income to their retirement accounts.” This is just a ballpark, but its worth aiming for. Stanford’s data from different providers shows that younger workers are averaging 7-8%contributions and older workers are averaging 9-10%.
Retirement plans offer at least four valuable features and we owe it to ourselves to take advantage of all of them.
1. The power of compounding over 30-40 years (and beyond)
Compounding gets us returns on our returns, period after period. The long-term results are significant. A contribution of just $100 per month for 40 years at say 5%average annual return will turn into $48,471 before taxes. If we start early and are consistent with our contributions, we can take advantage of the time value of money.
To illustrate the power of compounding, here is a picture of what a $100/month contribution compounds to in 40 years at 5% annual return (courtesy of the SEC retirement calculator)
2. Tax deferral
If you put money in a qualified retirement plan, you can avoid any tax for decades and continue compounding returns on the government’s money. We should be saving as much as we can in that account before saving money on a regular taxable account. Why ignore this gift?
3. Employer matches and profit-sharing
If you have these in your plan, they are the best gifts of all. People should go out of their way to maximize a 401(k) match if the employer provides one. It’s like getting 100%return on your money in the first year, with no risk. Its better by far to get a no-strings match than to be saving the same money in a regular account and forgo that added benefit.
As you can see from the numbers above, the retirement savings rate is still lower than it should be by good measure. Much of the problem of under saving has been attributed to behavioral factors – those subtle human biases that affect the way we make financial decisions.
The way our brain processes information predisposes us to make errors in financial judgment. Under saving for retirement is a prime example, even when we are making more than enough money to comfortably fund contributions. Worse yet, we save less in the early working years without realizing how much more we would need to save years later to make up the difference.
Behavioral studies point to a number of inherent biases and misjudgments that contribute to our tendency to under save for retirement.Among them are the following:
Behavioral biases like‘present bias’ and ‘hyperbolic discounting’
These are biases that cause us to value present rewards greater than future ones – especially ones that are too far out in the future to realistically project.
Time value of money illusion
On one hand, we tend to ignore the effects of inflation on what things will cost in 40-50 years. On the other, we also don’t consider the positive effects of compounding an investment over that period.
We tend to underestimate our own potential lifespans by subconsciously using the longevity of our parents and grandparents as a reference point.
Medical care illusion
Most of us have extremely low medical costs in our 20s and 30s other than health insurance itself. We don’t realize how much extra we may be spending when we are in our 70s, 80s and beyond.
Home value illusion
Many people feel that other savings & investments (most notably their homes)will provide them with an adequate retirement nest egg when the time comes. But you still need to live somewhere, so many people who eventually downsize,realize only partial benefit from their home values, and others are simply reluctant to give up their home at all when the time comes to stop working.
In short, we are not well-equipped to view our retirement needs realistically and objectively. As with healthy foods, we generally know which are good for us and which are not, but we succumb to eating a lot of the not-so-healthy ones anyway. We are the same way about money. As with diet and exercise, the journey begins with a single step. You should take that step with retirement savings as early as you can.
1. 2018 Report from Stanford Longevity Center
2. Investopedia’s Guide to 401(k) plans
3. SEC’s Compound Interest Calculator