As times have changed, so have our retirement plans. The ways that most American workers save today look very different from how they did just a few generations ago.
Up until World War II, retirement plans as we know them didn’t exist. When the influx of soldiers returned home from the war, big corporations offered a new benefit to attract better workers in the form of a retirement plan. In return for working a set number of years, often through the end of their careers, employees could enjoy knowing they would have a measure of financial security once they retired.
The idea of a pension, as this benefit came to be known, suited corporations because it encouraged loyalty and longevity. It suited employees because they knew they would be secure financially as they aged. Pensions were so popular that by 1970, 45 percent of all private sector employees received some kind of pension plan.
Where there is an upside, though, there is often a downside. While the pension was – and remains – a valuable benefit, this type of retirement plan left workers with no real choice in how to plan for retirement other than to work longer. The pension became a pair of golden handcuffs.
Then, the 70s happened, bringing with them disco, Woodstock, and very high interest rates. In an effort to offset some of the pain of those high rates and get the economy back under control, the federal government passed the Revenue Act of 1978. This legislation effectively created what is known as a “defined contribution plan,” otherwise known as 401(k)s.
The new era of retirement accounts had begun. Within 50 years, 69 percent of employees who were enrolled in a work-based retirement plan were enrolled in a 401(k), whereas just 24 percent of workers were lucky enough to be enrolled in both a pension and a 401(k), and only 7 percent were in a pension only.
Pension
American Express holds the distinction of offering the first ever pension, in 1875. Prior to this, businesses tended to be small or family-run, and it was up to the employee to consider how they would afford to retire one day.
Other large corporations joined American Express in offering a pension plan as an incentive to attract and keep workers. Typically, one had to work a set number of years (usually at least 20), and reach a certain age (usually 60), to receive a set, reduced amount of one’s salary in perpetuity. The upside was the considerable measure of financial security that this benefit offered to employees. The downside was that if a company declared bankruptcy, the money funding the pensions could be in jeopardy.
Unlike the combined contribution plan that is the 401(k), a pension is what’s known as a defined benefit plan. While all three of these accounts – 401(k)s, 403(b)s, and pensions – are now common employee benefits, only the pension functions purely as something you are given, and not something you control as an employee.
401(k)
The 401(k) account gets its name from the tax code used to define it. This type of plan is known as a defined contribution plan, meaning, quite simply, that employees are able to make contributions based on a defined set of rules.
The 401(k) offers more control to the individual employee than a pension, but also more risk. Arguably the biggest benefit to the 401(k) is the tremendous tax benefit that goes with it. As an employee, you can elect to move any dollar amount you wish, up to the federal maximum, from your pay check into a qualified investment account pre-tax. Many employers also match some or all of the money that employees elect to contribute, effectively increasing your overall compensation package.
Taxes will have to be paid on that money eventually, of course, but typically not until you retire, when you’ll be in a lower tax bracket anyway.
403(b)
A 403(b) account is, for all practical purposes, the same as a 401(k) in terms of what it is and what it does. The difference lies in who it’s for.
If you work for a school, a hospital, or possibly a church, your employer might offer a 403(b) as a retirement option. This account offers the same tax-deferment, the same employee control, and the same participation in money markets and investment funds.
Times Are Changing
In modern times, fewer people stay with companies long enough to earn a traditional pension, and so even companies that offer such a benefit are not as appealing as those that offer retirement plans that an employee can take with them job to job.
Regardless of your own retirement plan, always save as much as you can. Be involved in your retirement planning, and understand your assets. That way, time will be on your side and you will be ready to retire with confidence.