Retirement Investments: A Secure Future Or A Money Pit?

Retirement plans are a form of investment, but they are not the same as other types of investments. They are a strategy for long-term saving and investing, and eventually withdrawing money that you accumulate to achieve a financially comfortable retirement.

Retirement plans are not a static document. They are designed to be updated and reviewed over time to monitor progress. The earlier you start a retirement plan, the better.

There are two main types of retirement plans: defined benefit plans and defined contribution plans. Defined benefit plans promise a specified monthly benefit at retirement. Defined contribution plans, on the other hand, do not promise a specific amount of benefit at retirement. Instead, the employee or employer contributes to the employee's individual account, and these contributions are invested on the employee's behalf.

Defined contribution plans

In a defined contribution plan, employees can invest pre-tax dollars in the capital markets, where they can grow tax-deferred until retirement. This means that income tax will be paid on withdrawals at retirement age (minimum 59½ years old), but not before. The idea is that employees will be in a higher tax bracket during their working lives and will have a lower tax bracket when they are retired.

There are no guarantees with a defined contribution plan, and participation is voluntary and self-directed. The amount received upon retirement is not known in advance, as contribution levels can change, and investment returns may fluctuate over the years.

The most common defined contribution plans are 401(k) plans for employees of private companies, and 403(b) plans for employees of public schools, charities, some churches, and other nonprofit employees. In these plans, employees decide how much they want to contribute to their individual accounts, and their contributions are deducted from their paychecks and added to their accounts automatically. Employers may offer matching contributions, typically ranging from $0.50 per $1 contributed up to a specified percentage of the employee's salary (usually 3-6%).

As of December 31, 2021, defined contribution plans accounted for $11 trillion of the $34.2 trillion in total retirement plan assets held in the United States, according to the Investment Company Institute (ICI).

Traditional pensions

The traditional pension plan offers a guaranteed income stream during retirement, providing retirees with a fixed monthly payment for life. This stability is a significant advantage, ensuring a consistent income. Additionally, some defined-benefit plans provide cost-of-living adjustments to account for inflation, protecting retirees' purchasing power.

The pension funds are typically invested in a mix of bonds, stocks, and real estate. An emerging trend is to explore alternative investments, such as private equity, hedge funds, commodities, derivatives, and high-yield bonds, to achieve higher returns and greater diversity.

While traditional pension plans offer security, they also have limitations. Early withdrawals or loans are usually not allowed, and private pension plans often lack a cost-of-living escalator to adjust for inflation. Moreover, there is a risk of reduced benefits if the company's portfolio performs poorly or declares bankruptcy. However, private pension plans are eligible for coverage by the Pension Benefit Guaranty Corporation, which insures employees' pensions.

Overall, traditional pension plans provide retirees with a guaranteed income for life, shielding them from market risks and investment decision-making.

Guaranteed income annuities

For example, at age 50, you can begin making premium payments until age 65, when you plan to retire. Each payment you make increases your income for life. You can buy these on an after-tax basis, in which case you'll only pay tax on the plan's earnings. Or you can buy it within an IRA and get an upfront tax deduction, but the entire annuity will be taxable when you take withdrawals.

When you buy a lifetime annuity, you can't change your mind. Depending on how long you live, you might get less than you paid for your annuity. Although you could choose to provide an income or lump sum for a dependent when you die.

The amount of income you receive will depend on the annuity provider you choose, so it's important to shop around to ensure you're getting the best deal.

An income annuity works by converting a large sum of cash into a stream of regular payments. You give the money to an insurance company, and in exchange, the insurer agrees to pay you for a certain length of time or for the rest of your life.

Depending on your agreement, you might receive these payments monthly, quarterly, or annually. You can also customise your income annuity contract so that payments begin right away or at a later date. Like all annuities, income annuities offer tax deferral, meaning you pay ordinary income taxes only when you receive payments.

Income annuities can be immediate or deferred, and fixed, variable, or indexed.

Pros and Cons of Income Annuities

One advantage of income annuities is their customisability. Income annuities offer a wide variety of options for payments, allowing policyholders to choose the payment type that works best for them.

The biggest benefit of income annuities—specifically lifetime income annuities—is their insurance against outliving your retirement savings. The provider company guarantees your payments, even if your account balance reaches zero.

However, this fixed income might also be a drawback if your payouts remain consistent as living costs rise, reducing your purchasing power. Some insurers offer optional riders that increase your income payments to keep pace with inflation, but this perk comes at an extra cost.

And, like other types of annuities, income annuities lack cash liquidity. Because of this, an income annuity may not be right for someone without a robust emergency fund.

The Federal Thrift Savings Plan

The TSP closely resembles a 401(k) plan offered by private employers. TSP participants can get an immediate tax break for their savings and can also choose to invest in a Roth for freedom from taxes after retirement.

There are several ways to invest in a TSP, including automatic payroll contributions, agency matching contributions, tax-deferred contributions into a traditional TSP, and after-tax investments in a Roth TSP. The contribution limit for 2023 is $22,500 and $23,000 in 2024. Employees aged 50 and over can also make catch-up contributions of $7,500 in either year.

The TSP offers a choice of six funds and a mutual fund option:

• The Government Securities Investment (G) Fund
• The Fixed-Income Index Investment (F) Fund
• The Common-Stock Index Investment (C) Fund
• The Small-Capitalization Stock Index Investment (S) Fund
• The International-Stock Index Investment (I) Fund
• Specific Lifecycle (L) funds

The Federal Retirement Thrift Investment Board (FRTIB), an independent government agency, administers the TSP and acts as a fiduciary that is legally liable to manage the TSP prudently and in the best interests of participants and their beneficiaries.

The TSP is a valuable retirement planning option for government employees and service members, similar to those available to employees in the private sector.

Cash-value life insurance plans

Cash-value life insurance is more expensive than term life insurance. Term life insurance is designed to last for a limited period, and there is usually no cash value associated with it. However, it may be possible to convert a term life policy to whole life to obtain the cash value feature.

With cash-value life insurance, a portion of every premium payment goes towards a savings feature that collects interest over time. As the cash value grows, it can be used to make premium payments, borrow money, or withdraw cash. The cash value insurance feature is generally designed to benefit the policyholder while they are still alive, providing a loan option and a way to potentially reduce premium payments.

The cash value of life insurance earns interest, and taxes on the accumulated earnings are deferred. While premiums are paid and interest accrues, the cash value builds over time. As the life insurance cash value increases, the insurance company's risk decreases, as the accumulated cash value offsets part of the insurer's liability.

When considering cash-value life insurance, it is important to keep in mind that these policies are typically more expensive than regular life insurance due to the cash value element. Additionally, there may be tax implications when withdrawing more than the amount paid into the cash value.

Frequently asked questions