Written by: Greg Marchand | Marchand Financial Services, Inc
Don’t get me wrong. The 401(k), or any salary deferral vehicle, can be a great way to store and accumulate resources for your retirement. Many people unfortunately see their 401(k) as their only needed retirement vehicle, and I believe such limited planning will leave many retirees vulnerable to outliving their assets, and I think that may be leaving them very vulnerable.
Pensions provide income when we are done working. It is by far the most important financial goal for most of us. There two types of pensions – Defined Contribution and Defined Benefit. In defined contribution plans contribution amounts are determined, and that money is invested and the final result is uncertain. If the investments do well, the participant can retire comfortably. If the investment performance is a disappointment, then the participant has to rely on other resources or manage on less income than they wanted. A Defined Benefit plan determines the outcome wanted and then the plan is funded accordingly to reach that goal. If we look back prior to the 1970’s, most pensions in this country were defined benefit plans. Today, more and more of us are relying exclusively on a defined contribution plan (i.e., 401(k) plan).
Here are some of the potential characteristics of an individual defined benefit plan.
- No market risk
- Flexible contributions
- Income can be monthly or in one large payment
- Proceeds are usually tax free
- A portion of the contributions are available prior to retirement
There are at least five possible beneficiaries of the switch from defined benefits to defined contributions.
- The management companies (mutual funds)
- Investment advisors (I am one)
- The government (taxing 100% of distributions, and can control the timing of distributions)
- The employer
- The participant (employee).
There are three possible contributors. The employee, the employer, and the government. The government forgoes some tax revenue at the time of contribution. But, then they are entitled to tax the contributions, and the earnings, at the time of distribution. The employer will likely contribute a lot less under a defined contribution plan, and will definitely assume a lot less risk. The investment firms charge fees usually a percentage of assets. They get paid every day regardless of results. Advisors typically get paid constantly as well. So, everyone has the possibility to make money, but only 4 of the 5 are guaranteed to benefit. There is only one party that is at risk. Can you guess who that is?
In 1970, the size of the mutual fund industry in the USA was about $50 Billion. At the end of 2012, it was around $13 Trillion. Those numbers are estimates, they are not exact, and they change every month. We may agree that this has been a pretty good growth industry in the past 40 years. Can you see why it was easy for employers, the government, and the investment industry to agree to this change? Was the employee, who is the investor and beneficiary, adequately informed?
One last point:
Almost all defined benefit plans rely on the insurance industry to guarantee pension payments. Big Money does not take chances. The good news is that you can probably choose to also hire an insurance company or two, to guarantee your pension payments* (if your employer lets you, or once you leave the company). They won’t do it for free. But, if you are interested in transferring the risk to someone with bigger shoulders, it is an option.
My name is Greg Marchand. I have a series 7 securities license. I own an independent firm in Massachusetts. I have over 24 years of experience working directly with clients. I am a CLU, ChFC, and CFP®. I have three children, all boys. If I’m not working, and not playing, then I’m thinking about how I can be more effective for my clients. Contact me directly to schedule your free evaluation: (508)793-7841 or firstname.lastname@example.org.
*Guarantees are based on the claims paying ability of the issuing insurance company
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