In a previous article for this site, you learned a few methods for calculating your retirement number, the amount of savings you will have to accrue to maintain your standard of living after retiring at 65 years old. For many Americans, that number may be intimidating. Even the most conservative estimated retirement savings goal for a worker earning $100,000 in his or her final year of employment is $800,000. More commonly, personal financial advisors recommend a retirement savings equal to 11 or 12 times a client’s annual salary in his or her last year of employment. If a client’s date of retirement is more than years away, that number can climb as high as 16; owing to the likely exhaustion of Social Security funds by 2033.
If the prospect of saving that much money seems impossible, don’t worry. Your employer may offer one or more of a number of savings plans specifically designed to help you reach your retirement goals. In this article, we will look at employer-sponsored retirement savings plans.
Under a defined-benefit pension plan, companies promise to pay their workers a predetermined benefit for life upon retirement. These types of pension plans vary according to the manner in which employers calculate the post-retirement payments their employees receive. After retiring, workers whose employers offer a flat benefit plan continue to receive a fixed monthly payment—either a predetermined dollar amount, or a percentage of an employee’s average salary—provided they have been with the company for a specified number of years, and retire at a contractually agreed-upon age. Under a unit benefit plan, a vested employee receives a monthly post-retirement payment calculated by multiplying the number of years he or she has been with the company by either a fixed dollar amount, or a percentage of the employee’s average compensation.
Payments under a defined-benefit plan are guaranteed for the life of a retiree; meaning an employer is legally obligated to ensure the availability of funds sufficient to continue providing retirement benefits to each participating employee until death, even in the event that the company goes bankrupt. Even after death, the surviving spouse of a retiree can continue to receive benefits.
The money in a defined-benefit plan comes from tax-deductible contributions that an employer makes to a private pension fund. In addition to making regular contributions, a company agrees to pay the costs of managing and insuring its pension fund. Since 1974, the funds in a company’s defined-benefit plan are required to be held separately from its assets, and are insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency established under the Employee Retirement Income Security Act (ERISA); but a recent study suggests that 80% of the plans protected by PBGC are underfunded by a combined total of $740 billion, owing to weaker-than-expected investment returns. A 2012 report in the New York Times revealed that, of the 338 companies in the S&P 500 that provide defined benefit pension plans, only 61 were fully funded. In the event that a company fails to meet its obligations to its retired employees, the PBGC takes over the payment of benefits, but rarely at the full amount.
In recent years, large companies seeking to unload the annual burden of continuing to pay their salaried retirees have transferred their financial obligations to an insurance company, or simply offered lump-sum buyouts to pensioners.
A defined-contribution plan is any kind of employer-sponsored retirement benefit plan in which regular contributions are made to each individual employee’s retirement savings account. Depending on the type of plan offered, contributions are made by the employer, employee, or both. Annual contribution amounts are usually based on a percentage of an employee’s wages, but cannot exceed 100% of earnings, or $52,000—whichever is lower. Funds in an employee’s retirement savings account benefit from tax-deferred growth; meaning income derived from interest or investment returns is not subject to capital gains tax. The benefits that an employee receives following retirement depend upon how much money was contributed to his or her account, as well as the performance of pension fund investments. As with a defined-benefit plan, the employer assumes responsibility for the costs of managing (e.g. insuring, investing) the funds in a defined-contribution plan. Consequently, the employer usually has primary control over how pension funds are invested (learn more about mis sold investments).
Common examples of defined-contribution retirement savings plans are profit-sharing plans, 401(k)s, Simplified Employee Pension plans, Savings Incentive Match Plans for Employees, and money purchase plans.
Nearly all profit-sharing plans offered to employees working in the private sector are fully funded by an employer, whose annual contribution is tax-deductible. Under a profit-sharing plan, employees receive a portion of the total amount contributed to the plan each year by their employer.
The employer’s total contribution, and the method by which it is distributed among participating employees, is entirely discretionary; meaning there is no predetermined amount of money that an employer is required to contribute each year. Nonetheless, the IRS requires that employer contributions to a profit-sharing plan be “substantial and recurring.” Some employers may choose to contribute a fixed amount each year, while others determine their contribution based on the revenue growth or profit for that year.
Though an employer’s total annual contribution may fluctuate, the manner in which funds are allocated to individual participants must remain fixed, and apply fairly to all employees. Though some companies split the contribution equally among their employees, it is far more common to determine profit sharing allocations according to each employee’s annual wages, or the number of hours worked.
The United States Revenue Act of 1978 reduced corporate taxes, increased the standard deductions on individual tax returns, lowered the tax rate on capital gains, reduced individual income taxes by decreasing the number of tax brackets in the Internal Revenue Code, established Flexible Spending Accounts, and paved the way for the creation of the 401(k) pension plan that has since become the most widely available defined-contribution plan in American workplaces. Unlike a profit-sharing plan, which is typically funded solely by an employer, workers participating in a 401(k) contribute to their own retirement savings; but qualified 401(k)s offer several distinct benefits, making them an attractive alternative to traditional pension and profit-sharing plans.
First, since employees contribute to their own retirement accounts, their savings are not entirely dependent upon their employers’ discretionary contributions. Under a traditional profit-sharing plan, employers may choose to suspend annual contributions if revenues decline. An employee making regular contributions to his or her 401(k), therefore, has considerably more control over the amount of money contributed each year; and, since the money comes out of pre-tax wages, those contributions lowers the employee’s taxable income. Of course, there’s a limit to how much an employee can contribute. In 2014, employees under the age of 50 can contribute up to $17,500 to their qualified 401(k) retirement savings plans. Older employees can contribute an additional $5,500.
Second, many employers offer to match their employees’ 401(k) contributions—sometimes dollar-for-dollar. How much an employer chooses to match is discretionary, but contributions cannot exceed 25% of an employee’s total annual wages. In 2014, total contributions to an employee’s 401(k) plan (personal contribution plus matching funds) cannot exceed $52,000.
As with most employer-sponsored retirement savings plans, the cost of insuring and managing the funds held in 401(k) plans is assumed by the employer, who typically has full control over how funds are invested.
Simplified Employee Pension Plans (SEPs)
Small business owners, entrepreneurs, and anyone with income from self-employment who wants to create a retirement savings plan for themselves and their employees may be best served by setting up a Simplified Employee Pension plan, or SEP. Under a SEP, a self-employed business-owner can contribute of to 18.6% of his or her business’s net profit to an individual retirement account. Business owners who pay themselves a salary from their company’s revenues can contribute up to 25% of their annual net wages, but must extend the same retirement benefit to any employee who is at least 21 years old, earns at least $550 annually, and has been employed by the company at least three of the past five years.
Savings Incentive Match Plans for Employees (SIMPLEs)
A Savings Incentive Match Plan for Employees, or SIMPLE, is designed specifically for businesses with fewer than 100 employees. It shares many of the same benefits as more conventional retirement savings plans, but costs considerably less to set up and maintain than a 401(k). Employers can set up a SIMPLE for their employees only if they currently have no other retirement savings plan.
Employer contributions to a SIMPLE are mandatory. Under a SIMPLE, employers must make contributions to their employees’ retirement savings accounts, regardless of whether those employees make their own contributions, or how long they’ve worked for the company. The minimum employer contribution for workers not contributing to their retirement plan is 2% of those employees’ net wages; but employees that do contribute to their plans can receive matching payments up to 3% of their wages.