Will Your Pension Plan Last 10 Years After You Retire?
Creating A Resilient Pension Plan
A pension is a type of retirement plan that can provide you with a steady form of income (made in monthly payments) when you stop working. If you’re not enrolled in a pension plan, you need to read this post! Creating a plan will make the possibility of your retirement much more likely and make the entire experience much easier for you when the time comes.
If you are enrolled in a pension plan, it’s important for you to understand what type of plan you have. If you are an employee of a company, you need to find out whether your plan is a defined contribution or defined benefit plan.
Defined Benefit Pension Plans
Under a defined benefit pension plan, your employer promises to give you a definite payment or lump sum of money when you retire. They’ll use a range of factors to determine your payment amounts including your age, proposed retirement date, the amount of time you’ve spent with the company, and the amount of money you earned while you worked there. These plans were once the most commonly used, especially by government corporations and larger firms.
Here’s an example of how your pension would be calculated under a defined benefit pension plan:
GMS Company promises the following as a part of your plan:
During retirement, the company will make a monthly payment to you, which will be determined by the number of years of service (multiplied by 2%); and
GMS Company will multiply the above figure by your average salary for the last 5 years.
Let’s say that you have 30 years of work experience and an 5 year average annual salary of $50,000. A simple example of what your formula would look like is:
30 years x 2 percent x $50,000 = $30,000
$30,000 will be your annual pension payout. To find your monthly payout, divide $30,000 by 12 months.
$30,000/12 months = $2,500
The longer you work for the firm and the more money you make, the higher your pension payment will be. This example plan will replace 60% of your income when you retire.
For the employee, a defined benefit plan only accumulates as a savings plan as opposed to an investment plan. This is because your payments are not determined on how well your money grows in an investment portfolio. Instead, your payments will be determined by the promise of your employee.
Defined Contribution Pension Plan
Defined contribution plans are the most common type of pension plans used today. As a part of this type of plan, you make regular contributions that go into the plan that accumulate overtime. If you work for a company that offers this kind of pension plan, its likely that you and your employer are paying into it. This is called employer matching.
Under most pension plans, a person is required to put a minimum of 5% into the plan with the employer matching their contribution. Some companies are generous enough to match up to 10% of your contributions. In this instance, the “matched” amount that you are receiving can essentially be viewed as ‘free money’ from the company. It is always prudent to contribute as much as your company would match so that you can maximize this benefit. However, it’s important to be vested to receive this benefit.
Vesting Period
A vesting period is the number of years that you must participate in a plan to receive its full benefits. As a defined benefit pension member, you can keep your contributions and those that your employer made when the pension is paid even if you leave the company and exit the plan once you’ve been vested. If you do not meet the vesting period you would only receive your contributions - not the amounts that your employer matched on your behalf.
Inflation Adjustments
Inflation is a major problem for retirees as their pension payments are fixed while the cost of living continues to rise. Given the savings account nature of defined contribution plans, there is little in the form of inflation protection for investors as they must use returns from investments to offset inflation. However, in defined benefit plans, many companies have built cost of living adjustments into them at different intervals. The plan administrators will assess inflation in the economy and may be mandated to increase pension payments to match the increase in prices.
It is important to talk to your employer about the type of pension plan offered. If you are self-employed, talk to a pension fund administrator about your options for a personal pension plan. Remember that it is crucial to save outside of your pension plan for rainy days. To get the full scope of how to retire comfortably, check out our blog post Five Financial Tips to Retire Effectively. We hope that these resources will help you GET MONEY SMART as you begin to analyze pension plans.