Rethinking Retirement: The Surprising Cost Benefits of Pension Plans
The era of traditional pension plans is largely a thing of the past in the United States, replaced by defined contribution retirement vehicles like 401(k) plans. However, a recent study by the National Institute on Retirement Security suggests that this shift may not be as beneficial to companies as previously thought. In fact, providing employees with a traditional pension plan may actually be more cost-effective than operating a 401(k) or other defined contribution plan.
The Cost Conundrum: Why 401(k) Plans May Be More Expensive
The reasoning behind companies’ desire to switch to defined contribution plans is straightforward. With a traditional pension plan, the company is responsible for a predetermined payment every year until a worker’s passing, which can become costly if employees live longer than expected. In contrast, defined contribution plans like 401(k)s shift the payment burden to the employee, based on their individual savings. However, the group nature of pension plans may actually result in lower costs for employers, according to the NIRS study.
Economies of Scale and Risk Pooling
“Pensions have economies of scale and risk pooling that just can’t be replicated by individual savings accounts,” notes Dan Doonan, executive director of NIRS. “This means pensions can provide retirement benefits at a much lower cost.” The study found that to replace 54% of income for employees after retirement, a defined benefit (DB) plan required contributions of 16.5% of total payroll, while a defined contribution (DC) plan required 32.3% of payroll to achieve the same goal.
Pension Plan Basics: How They Work
A pension plan operates by pooling contributions from both the company and enrolled employees. The money is invested in the market, and a board or financial advisor makes investment decisions. The pool is then used to pay predetermined amounts to retired employees, often based on their length of service and salary.
401(k) Plan Basics: A More Individualistic Approach
In contrast, 401(k) plans are more individualistic. Each person contributes to their own account, choosing from a menu of investment options. Once they retire, they schedule their own drawdown plan to take money out as needed. Contributions are made pre-tax, and participants pay taxes when they withdraw funds in retirement. Some employers offer a match, contributing a certain amount based on employee contributions.
The Bottom Line: Rethinking Retirement Planning
For decades, pension plans have been phased out in favor of defined contribution plans, except in a few industries. However, new research suggests that pension plans may actually cost employers less than offering a 401(k) plan. Regardless of the type of retirement plan your company offers, a financial advisor can help you plan for your golden years.
Retirement Planning Tips
- Use SmartAsset’s retirement calculator to determine how much you’ll need to live your retirement dreams.
- Keep an emergency fund on hand in case of unexpected expenses.
- Consider consulting a financial advisor for professional guidance through legislative changes and beyond.
Finding the Right Financial Advisor
SmartAsset’s free tool matches you with up to three financial advisors in your area, allowing you to interview and choose the right advisor for your needs. Get started today and take the first step towards achieving your financial goals.
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