When it comes to employer-sponsored retirement plans, defined contribution plans are the new retirement reality for the majority of workers today. Once upon a time, defined benefit pension plans were the norm, but increasingly, they’re mostly for government workers. In the following post, we review the reasons for this shift and what you can do if you’re in the likely position of having a defined contribution plan at work.
The State of U.S. Retirement Accounts
The chart below, based on data from the Investment Company Institute, shows the breakdown of the $19.5 trillion retirement assets in the US. As you can see, 401k assets – the most popular form of defined contribution plans –increased by $600 billion from 2007 to 2012 to $3.6 trillion. Over the same period, private defined benefits plans remained steady at $2.6 trillion, and government pensions increased slightly from $4.6 trillion to $4.8 trillion
Fewer than 18 per cent of workers in the private-sector are covered by defined benefit plans, down from 35 per cent in the early 1990’s, according to the Bureau of Labor. As the chart above indicates, they’re still prevalent for public sector employers (78 percent) and in unionized workplaces (67 percent).
Shifting Risk to You
So what has driven this shift from defined benefit to defined contribution plans? Most importantly, defined contribution plans transfer risk from company balance sheets to their employees. That means: a company is not on the hook to invest on behalf of an employee, or to pay her distributions during retirement. Accounting changes, increased life expectancy and now, a low interest rate environment (which has contributed to under-funding of pensions) have also contributed to make pensions less attractive for companies.
Defined Benefits Have Their Perks – and Limits
Defined benefit plans are often considered the cream of the crop of workplace pension plans. They’re “guaranteed” income during retirement. An employer pays you what you are owed, and financial planning becomes a lot easier.
But defined benefit plans have their limits. First, they often come with restrictions. You may need to be tenured at the company for a certain length of time to participate in the pension plan, or you may not be entitled to your assets if you leave the company.
And another catch – the current low interest rate environment poses challenges for the funding levels of pension plans. The unfunded pension liability for cities and counties has a $574 billion shortfall, according to a Northwestern University study. In the bankruptcy proceedings in Detroit, the pension plans are part of the city’s obligations that may not be met – evidence that defined benefit pension plans are not far from a sure thing and may not be there when you need them most in retirement.
Defined Contribution – The New Kid on the Block
With defined contribution pension plans, the only thing that is known in advance are the employee and employer contributions.
Unfortunately for U.S. workers, retirement outcomes have proven to be worse in defined contribution plans. More than just the shift in risk, people are simply not saving enough (behavioral economists have suggested that it’s because saving requires more self-control).
However, defined contribution plans can be great savings vehicles. First, they typically have fewer restrictions relative to pensions; you can generally start contributing immediately and can take the assets if you leave your employer. Second, you have greater control over your investments because you’re able to design your portfolio.
If you’re in a defined contribution plan, read on! In the next section, we outline how to make the most of your plan.
Optimizing of Your Defined Contribution Plan
While you may have little choice when it comes to your workplace retirement plan, there’s often still room for you to make decisions that improve your potential investment outcome. If you have a 401k plan at work, here are some helpful tips.
- Save, and Take Advantage of Your Employer Match. The first thing you need to do is save. Nearly half of 401k plans have automatic” enrollment, with a typical “default” savings rate of 3% of your salary. If you’re savings less than that (and still under the $17,500 annual maximum), it may be time to increase your contributions. Many employers offer matching contributions, which will increase your savings. For example, some plans offer a 50 percent match up the first 5 percent of your gross annual salary, while a more generous plan will offer you a dollar for dollar match. To make sure you make the most of your employer match, ask your human resources department for a summary of your 401k matching program. By not taking full advantage of your employer match, you’re leaving free money on the table.
- Go Roth – or Not. Since 2006, an increasing number of employers allow you to decide whether to structure your retirement savings as a Roth 401k. As we wrote in a recent blog post on “going Roth,” in many cases that can eventually lower your tax bill. Generally speaking, if you expect your taxable income to be lower in retirement, you’re more likely better off with a normal 401k.
- Review your Investment Selection. Do you know what assets are in your 401k? And how they impact your overall allocation. It’s a best practice to review your 401k portfolio on at least an annual basis. You’ll want to ensure your asset allocation remains on target and that your investment selection is in line with your time horizon and tolerance for risk. For major life events – your spouse loses her job or you’re expecting a child – it’s an ideal time to reevaluate your investment portfolio. Not sure how to optimize your investments for the ideal asset allocation? Try our new Investment Checkup for help diagnosing the health of your portfolio.