Retirement Funds: The Investment Conundrum

Retirement plans are a form of investment, and there are many different types of retirement plans available. These include 401(k) plans, 403(b) plans, individual retirement accounts (IRAs), and annuities. The best retirement plan for an individual will depend on their financial situation, goals, and risk tolerance.

Retirement plans are a strategy for long-term saving and investing, with the goal of achieving a financially comfortable retirement. They are an important way to ensure that individuals have enough money to maintain their lifestyle after they stop working. While Social Security benefits can provide some income during retirement, they typically only replace about 40% of pre-retirement earnings. Therefore, it is crucial for individuals to have a viable long-term plan to secure their financial future.

The two main types of retirement plans are defined benefit plans and defined contribution plans. Defined benefit plans promise a specified monthly benefit at retirement, which is often calculated based on factors such as salary and years of service. On the other hand, defined contribution plans do not guarantee a specific benefit amount. Instead, the employee or employer contributes to an individual account, and the employee ultimately receives the balance, which includes investment gains or losses.

Retirement plans can be offered by employers, such as 401(k) or 403(b) plans, or they can be set up individually, such as with an IRA. It is important to consider the tax advantages of different retirement plans, as well as the level of risk and potential returns. Seeking advice from a financial professional can help individuals determine the most appropriate retirement plan and investment strategy for their circumstances.

Defined contribution plans

In a defined contribution plan, employees decide how much they want to contribute to their individual accounts, and this amount is automatically deducted from their paychecks. Employers may also offer matching contributions, where they add a portion of the employee's contribution, up to a certain percentage of their salary. These plans usually have restrictions on when and how employees can withdraw funds without penalties.

One of the advantages of defined contribution plans is that they offer tax benefits. Contributions are often made with pre-tax dollars, and the investments grow tax-free until withdrawal during retirement. This means that income tax is only paid on withdrawals, typically after reaching retirement age (minimum 59½ years old). Additionally, some defined contribution plans, like the Roth 401(k), allow employees to contribute after-tax dollars, which can then be withdrawn tax-free during retirement.

Another advantage is that defined contribution plans give employees control over their investment choices. Most plans offer several investment options with different fee structures and risk profiles. Employees can choose how to invest their contributions based on their financial goals and risk tolerance.

However, defined contribution plans also come with limitations. Since there are no guarantees, employees need to ensure they are contributing enough and investing wisely to secure their retirement income. Managing investments can be challenging for those without financial expertise, and there is a risk of investing in improperly managed portfolios.

Overall, defined contribution plans offer employees a tax-advantaged way to save for retirement, with control over their contribution amounts and investment choices. However, it is essential to carefully consider investment options and plan for the long term to ensure a comfortable retirement.

Traditional pensions

Pensions are fully funded by employers and provide a fixed monthly benefit to workers at retirement. They are one of the easiest retirement plans to manage because so little is required of employees. However, they are becoming less common as they are expensive and unpredictable for employers. Defined-contribution plans, such as 401(k)s, are now more common as they shift the burden of saving and investing onto employees and are less costly for employers.

In 1980, traditional pensions covered 38% of private-sector workers, but by 2020, this had dropped to 12 million active participants. In contrast, the number of active participants in defined-contribution plans like 401(k)s soared from 11.2 million in 1975 to 85.3 million in 2020.

The workers most likely to still have a traditional pension are unionised workers in both the public and private sectors, as well as active-duty military members with at least 20 years of service.

With a traditional pension, employees won't get much for their service in retirement unless they stay with the same employer for a very long time. And even if they do, they may not get much out of the plan if they die soon after retiring, as not all plans allow workers to leave their pension to their families.

There are two main types of pension plans: the defined-benefit plan and the defined-contribution plan. In a defined-benefit plan, the employer guarantees the employee will receive a specific monthly payment after retiring and for life, regardless of the performance of the underlying investment pool. The defined-contribution plan, on the other hand, is an investment account that's funded primarily by an employee and grows throughout their working years.

Guaranteed income annuities

Annuities are sold by insurance companies and provide a regular guaranteed income in retirement. You can buy an annuity with some or all of your pension pot. It pays income either for life or for an agreed number of years.

When you use money from your pension pot to buy an annuity, you can take up to a quarter (25%) of the amount as tax-free cash. You can then use the rest to buy the annuity – and the income you get is taxed as earnings.

Types of Annuities

There are two main types of guaranteed income annuities:

• Immediate income annuities: Income payments will begin within a year of purchasing the annuity.
• Deferred income annuities: Income payments will begin one year or more after purchase.

There are also two other types of annuities:

• Investment-linked annuities: This is a type of lifetime annuity where part of your income is guaranteed, and part is linked to investment performance.
• Purchased life annuity: You can buy this type of annuity with money that’s not in your pension pot, or with the tax-free lump sum you can take when you begin taking money from your pension.

Advantages and Disadvantages

One of the biggest advantages of guaranteed income annuities is that they provide a hedge against outliving your savings. They also offer customizability, with a wide variety of options for payments.

However, one of the disadvantages is that they are illiquid. Deposits into annuity contracts are typically locked up for an extended period of time, known as the surrender period, and you will incur a penalty if you withdraw during this time.

Individual Retirement Accounts (IRAs)

There are several types of IRAs, each with different rules regarding eligibility, taxation, and withdrawals. These include:

• Traditional IRA: Contributions are typically tax-deductible. Taxes are paid on withdrawals in retirement.
• Roth IRA: Contributions are made with after-tax funds and are not tax-deductible, but earnings and withdrawals are tax-free.
• Simplified Employee Pension (SEP) IRA: Allows employers, typically small businesses or self-employed individuals, to make retirement plan contributions into a traditional IRA established in the employee's name.
• Savings Incentive Match Plan for Employees (SIMPLE) IRA: Available to small businesses that do not have any other retirement savings plan. The SIMPLE IRA allows employer and employee contributions, with simpler, less costly administration and lower contribution limits than a 401(k).

IRAs can be opened through a bank, an investment company, an online brokerage, or a personal broker. Individuals can contribute up to the maximum amount allowed by the Internal Revenue Service (IRS). Money held in an IRA usually cannot be withdrawn before age 59 1/2 without incurring a hefty tax penalty of 10% of the amount withdrawn, in addition to normal taxes. However, there are some exceptions to this penalty for medical expenses, disabilities, first-time home purchases, and other unusual life events.

401(k) plans

A 401(k) plan is a tax-advantaged retirement savings plan that allows employees to contribute a portion of their wages to individual accounts. The name comes from a section of the US Internal Revenue Code.

There are two types of 401(k) plans: traditional and Roth. With a traditional 401(k), contributions are made from pre-tax wages, meaning they are not considered taxable income. However, distributions are taxed at retirement. With a Roth 401(k), contributions are made with after-tax income, and withdrawals are not taxed.

Employees can choose from a variety of investment options, typically mutual funds, and their money is invested according to their choices.

Advantages of a 401(k) plan

Disadvantages of a 401(k) plan

One key disadvantage is that there may be penalties for accessing the money, and it may be difficult to withdraw without paying taxes. Investment options are limited to the funds provided by the employer.

Frequently asked questions