Retirement Plan Basics
By: Financial Hotline
Spring 2022 (Vol. 40, No. 1)
It’s never too early or too late to start planning for retirement. If you have a retirement plan, it’s time for a review to insure it is on target with your current goals. Here are some basic topics to help you get started or stay on track:
I want to set up a retirement plan, but my employer doesn’t offer anything. What are my options?
You can set up a traditional IRA. This is a tax-advantaged personal savings plan where contributions may be tax deductible to you depending on your income.
You can also choose to open a Roth IRA which is a tax-advantaged personal savings plan. The contributions you make today are not deductible, but your money does grow tax free and distributions you take in retirement are tax free. If you have self-employment income, you may also consider a SEP IRA or a Solo 401k.
What does it mean when my employer matches my retirement plan contribution?
FREE MONEY. The specific terms and amounts on employer matched plans vary widely but the general idea is every time you contribute to your plan, your employer will make either a certain percentage or a dollar-for-dollar matching contribution. Basically, they are paying you to invest in yourself, so it makes sense to maximize this benefit.
I have been offered starting positions by three major employers. Can you give me a basic overview of different retirement benefit plans?
There are many types of plans that an employer may use. The Employee Retirement Income Security Act (ERISA) covers two types of plans:
A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $500 per month at retirement. Or it may calculate a benefit through a plan formula that considers such factors as salary and service. The benefits in most traditional defined benefit plans are protected through the Pension Benefit Guaranty Corporation (PBGC).
A defined contribution plan, on the other hand, does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee’s individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually. These contributions generally are invested on the employee’s behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.
Employers have many options to choose from and may also use a combination of plans. Some common options include:
Simplified Employee Pension Plan (SEP). A SEP allows employees to make contributions on a tax-favored basis to individual retirement accounts (IRAs) owned by the employees. Under a SEP, an employee must set up an IRA to accept the employer’s contributions. After 1997, employers may no longer set up Salary Reduction SEPs. However, employers are permitted to establish SIMPLE IRA plans with salary reduction contributions. If an employer had a salary reduction SEP prior to 1997, they may continue to allow salary reduction contributions to the plan.
Another option is a Profit Sharing Plan or Stock Bonus Plan. This is a defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution. A profit sharing plan or stock bonus plan may include a 401(k) plan.
A 401(k) Plan is a defined contribution plan that is a cash or deferred arrangement. Employees can elect to defer receiving a portion of their salary which is instead contributed on their behalf, before taxes, to the 401(k) plan. Sometimes the employer may match these contributions. An employer must advise employees of any limits that may apply. Employees who participate in 401(k) plans assume responsibility for their retirement income by contributing part of their salary and, in many instances, by directing their own investments.
An Employee Stock Ownership Plan (ESOP) is a form of defined contribution plan in which the investments are primarily in employer stock.
A Cash Balance Plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance. In a typical cash balance plan, a participant’s account is credited each year with a “pay credit” (such as 5 percent of compensation from his or her employer) and an “interest credit” (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer. When the participant retires, they receive benefits based on their account balance.
Your employer may also choose to use a plan that combines both defined contributions and defined benefits.
How important are my asset allocations?
Your asset allocations play a major role in how fast your account will grow. Basically, you’re trying to pick a mix of assets that has the highest probability of meeting your goal at a level of risk you can live with. A rule of thumb is that you should hold the percentage of stocks in your portfolio that is equal to 110 minus your age. So, if you are 30, then you would have 80 percent invested in stocks and 30 percent in bonds. However, since not everyone’s retirement date and circumstances are equal, it’s always best to do a personalized review.
Another thing to consider is your time horizon. This is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment while an investor saving up for a teenager’s college education would likely take on less risk because they would be needing to cash out faster.
What is a diversified portfolio?
Diversifying your portfolio is the equivalent of ‘not putting all your eggs in one basket.’
Stocks, bonds, and cash are the most common asset categories. But other asset categories - including real estate, precious metals and other commodities, and private equity - also exist, and some investors may include these asset categories within a portfolio.
Stocks are considered the “heavy hitter” since they have historically had the greatest risk and highest returns among the three major asset categories. But they still strike out occasionally. The volatility of stocks can make them a risky investment in the short term.
Bonds are generally less volatile than stocks but offer more modest returns. As a result, an investor approaching a financial goal might increase his or her bond holdings relative to his or her stock holdings because the reduced risk of holding more bonds would be attractive to the investor despite their lower potential for growth. You should keep in mind that certain categories of bonds offer high returns similar to stocks. But these bonds, known as high-yield or junk bonds, also carry higher risk.
Cash and cash equivalents - such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds - are the safest investments, but offer the lowest return of the three major asset categories. Equivalents do occur, but infrequently.