Retirement Planning: Best Funds For A Secure Future

Retirement funds are an important way to ensure financial security for the future. There are many options available, each with their own advantages and disadvantages. For example, defined contribution plans, such as 401(k)s, are common and allow employees to contribute pre-tax wages to their retirement fund, which then grows tax-free until withdrawal. Alternatively, there are defined-benefit plans, like traditional pensions, which are funded by employers and provide a fixed monthly benefit to retirees. When choosing a retirement fund, it is important to consider factors such as risk tolerance, diversification, fees, and investment options. Seeking advice from a financial advisor can also help individuals make informed decisions about their retirement funds.

Defined contribution plans

The 401(k) plan is the most common defined contribution plan, where employees can elect to defer receiving a portion of their salary, which is instead contributed on their behalf before taxes. The 403(b) plan is typically open to employees of nonprofit corporations, such as schools, while the 457 plan is available to employees of certain types of nonprofit businesses as well as state and municipal employees.

The Thrift Savings Plan (TSP) is another defined contribution plan, available to federal government employees. TSP participants choose from five low-cost investment options, including a bond fund, an S&P 500 index fund, a small-cap fund, and an international stock fund. Federal employees can also receive a 5% employer contribution to the TSP.

• Portability: You can take your 401(k) or 403(b) to another employer when you change jobs or even roll it into an IRA.
• Potential for higher returns: A 401(k) or 403(b) may offer higher returns because it can be invested in higher-return assets such as stocks.
• Freedom: A defined contribution plan gives you the ability to leave an employer without fear of losing retirement benefits.
• Not reliant on your employer's success: Receiving an adequate pension may depend a lot on the continued existence of your employer.

However, defined-benefit plans offer the advantage of income that shouldn't run out, as it typically pays until the recipient's death. They also don't need to be managed by the recipient, as the employer takes care of it.

Traditional pensions

Pensions are fully funded by employers and provide workers with a fixed monthly benefit upon retirement. However, defined benefit plans are becoming less common, with fewer companies offering them. In 2019, only 14% of Fortune 500 companies offered pension plans to new workers, down from 59% in 1998. This is because defined benefit plans require employers to make good on an expensive promise to fund a large sum for an employee's retirement.

Pensions are payable for life and usually replace a percentage of an employee's pay based on their tenure and salary. A common formula is 1.5% of final average compensation multiplied by years of service. For example, a worker with an average pay of $50,000 over a 25-year career would receive an annual pension payout of $18,750, or $1,562.50 per month.

This type of plan addresses longevity risk, or the risk of running out of money before death. According to David Littell, professor emeritus of taxation at The American College of Financial Services, "If you understand that your company is providing a replacement of 30% to 40% of your pay for the rest of your life, plus you're getting 40% from Social Security, this provides a strong baseline of financial security. Additional savings can help but are not as central to your retirement security."

Since the pension formula is generally tied to years of service and compensation, the benefit grows more rapidly at the end of an employee's career. Therefore, if an employee were to change jobs or if the company were to terminate the plan before the employee retires, they would receive a much lower benefit than originally expected.

As traditional company pensions are increasingly rare and valuable, deciding whether to leave a company can be a major decision. Employees need to consider the financial strength of their employer, how long they have been with the company, and how close they are to retiring. They can also factor in their job satisfaction and whether there are better employment opportunities elsewhere.

Guaranteed income annuities

For example, at age 50, you can start making premium payments until age 65, if that's when you plan to retire. Each time you make a payment, your future monthly payment increases. 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 make withdrawals.

Deferred income annuities (DIAs) are a good option for pre-retirees between the ages of 55 and 65 who are planning to retire in 5 to 10 years. They have several advantages over immediate annuities:

• Potentially higher income: Because DIAs have a deferral period, the underlying investments have a longer duration and higher potential returns than annuities that start income payments immediately.
• Chance to vary your interest rate exposure: With any fixed-income annuity, the price you pay depends on the interest rates at the time of purchase. Because you can add to your DIA before starting your income, you can adjust your interest rate exposure over time.
• A reason to stay the course: Locking in some guaranteed income through a DIA now may give you the confidence to maintain your target asset mix through market ups and downs.
• A means of reducing risk: Pre-retirees tend to shift to more conservative investments as retirement draws closer. Establishing guaranteed income well before retirement with a DIA puts that risk-reduction process in motion automatically.

Remember, though, that DIAs, like any investment product, aren't right for everyone. There is an element of trading investment portfolio growth potential for a guaranteed lifetime income stream when you need it. Part of that trade-off is giving up some flexibility (access), which is why it’s better to allocate a portion, rather than all, of your savings to a DIA.

The Federal Thrift Savings Plan

The Thrift Savings Plan (TSP) is a defined-contribution retirement savings and investment plan for federal employees and uniformed service members. It offers the same type of savings and tax benefits that many private corporations offer their employees under 401(k) plans.

By participating in the TSP, federal employees and uniformed service members can save part of their income for retirement, receive matching agency contributions, and reduce their current taxes. The TSP is like a 401(k) plan on steroids.

Participants can choose from five low-cost investment options, including a bond fund, an S&P 500 index fund, a small-cap fund, and an international stock fund. There is also a fund that invests in specially issued Treasury securities.

Federal workers can also choose from several lifecycle funds with different target retirement dates that invest in those core funds, making investment decisions relatively easy.

Federal employees can get a 5% employer contribution to the TSP, which includes a 1% non-elective contribution, a dollar-for-dollar match for the next 3%, and a 50% match for the next 2%. The investment fees are very low, at four-hundredths of a percentage point, or 40 cents annually per $1,000 invested.

The contribution limit for a TSP in 2024 is $23,000, and employees aged 50 or older can make catch-up contributions of $7,500. Employees who are new to federal employment can roll over 401(k) and individual retirement account (IRA) assets into a TSP, and vice versa if federal employees move to the private sector.

Cash-value life insurance plans

Cash-value life insurance is a unique product, and comparing policies can be challenging. The risk element, or the mortality cost, is the price a consumer pays for protection against premature death. However, unlike other forms of insurance, the risk of dying is 100% for everyone – it's just not clear when it will happen. With cash-value life insurance, the insurer overcharges for coverage when the policyholder is younger so that the price is more manageable in later years. The excess premium dollars charged in the early years are then invested.

There are several types of cash-value life insurance plans, including whole life insurance, universal life, and variable life insurance. Whole life insurance charges a fixed premium and guarantees a minimum return on the invested dollars, which is paid to the policyholder as a tax-free dividend. Universal life insurance allows for flexible premiums and credits an interest rate to the cash value that is associated with the insurer's investment experience. Variable life insurance allows the policyholder to determine where the cash value is invested but also assumes the investment risk.

• Fit the product to your profile: Cash-value policies differ widely, so it's important to determine your needs and find a policy that addresses them. For example, consider whether you need flexibility in premium payments, are comfortable with additional risk for a potentially higher return, and how likely you are to access the cash value.
• Involve an advisor: While it may be tempting to cut out the middleman, a professional advisor can help you sort through the complex options, apply for the right product, and assist with the underwriting process. They can also provide ongoing monitoring and help execute your plan once you retire.
• Question policy illustrations: Policy illustrations are a handy way to demonstrate how a policy will work under certain assumptions, but they can no longer be relied on as an indicator of future performance due to market volatility. It's important to carefully review policy illustrations and understand the assumptions and risks involved.
• Avoid borrowing to pay premiums: Structured premium borrowing techniques can work in certain situations, but they generally involve taking on additional risk. Life insurance is typically purchased to reduce risk, not increase it.
• Build your insurance plan into your retirement plan: Cash-value life insurance requires active management, and you'll need to determine if and when to utilize the policy's cash values to supplement your retirement plan. This may involve creating a targeted withdrawal strategy and making adjustments over time.

In summary, cash-value life insurance can be a valuable tool for retirement planning, providing tax advantages, protection for loved ones, and financial flexibility. However, it's important to carefully evaluate the different types of policies and seek professional advice to find the best fit for your specific needs and goals.

Frequently asked questions