Wednesday, May 22, 2013

Retirement Options: Defined vs. Contribution Plans

When planning for retirement, many employees overlook the different investment options available. Which is not surprising, since the entire process is a complicated one. Add to that the fact that many companies assume their workers are aware of those options and neglect to mention them. But with the return on investments as disappointing as it has been this past decade, it is important to understand the types of retirement plans available. Knowledge gives us the opportunity to make the right choices and to invest in different plans.

Retirement plans fall under two main categories: defined benefit  and defined contribution plans. Each one has its benefits and its setbacks, as every investment does, but they are similar because they give individuals something to fall back on when retirement rolls along. If possible, investors can secure their retirement even more by committing to both types.

For the sake of simplicity, I will list their differences below:

Defined benefit plan
  • Generally funded by only the employer, although some plans allow employees to also contribute.
  • Contribution is pre-determined by a formula that uses the investor's age, years of service, and salary.
  • Employees receive monthly benefits for life.
  • Unlike the contribution plan, where the final return depends on how well an investment performed, monthly benefits are more predictable.

Defined contribution plan
  • Employees choose a class of assets to invest in and determine the percentage of their salary to set aside, which is then matched by the employer.
  • Investment grows relevant to the portion of your salary and the type of assets in your portfolio.
  • Employees can start using the money once they retire.

The benefits/setbacks to each plan are:

Defined benefit plan
  • Employee is relieved from having to contribute to the fund.
  • Benefits are established by a formula and not the return on investments.
  • Employees are entitled to the benefits should they decide to retire early.
Defined contribution plan
  • Gives employees more control over funding their own retirement.
  • Investment grows by the amount contributed and the employer's matched rate, as well as growth in the available assets.
  • Employees have greater flexibility in adjusting the amount they want to invest.
It's important to note that even if you're not working a full-time job, you can save for your future by investing in either an Individual Retirement Account (IRA) or Simplified Employee Pension (SEP). While the IRA is available to anyone, it gives those individuals not in the workforce the opportunity to set some money aside for retirement. If you're working part-time or as a contractor, you may be entitled to the SEP, which is completely funded by the employer.

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