How Sturdy is your Three-Legged Stool?
Retirement sources of income have often been compared to a three-legged stool.
The first leg of that stool is Social Security. The second is your employer’s pension plan. And the third is your personal savings.
Social Security was designed to provide a minimum level of support (subsistence level). That is why it’s also known as social insurance.
For every dollar (up to certain limits) you earn today, the government takes a percentage to support Social Security and Medicare. Your employer is also required to match your amount. If you are self-employed, you must pay this ‘match’ yourself. If you have a history of higher earnings, Social Security will replace a lower percentage of your pre-retirement income than if your earnings were low.
A pension plan is a very important employee benefit. There are two types of these—defined-benefit and defined-contribution plans. A defined-benefit plan pays retirement income to plan participants and is usually provided to them at no cost. A defined-contribution plan provides an annual contribution to an account in the participant’s name. A defined-benefit plan will typically allow you a choice of several different payout options. Most defined-contribution plans provide a lump-sum distribution that you can either invest yourself or annuitize to receive a monthly income over your lifetime.
If you have participated in a defined-benefit plan, and you’ve had multiple jobs, chances are your anticipated retirement income won’t be as large as you might expect. You’ll typically receive a substantially smaller benefit from a combination of defined-benefit plans from different employers than if you had continued earning benefits under one plan for a long period of time. That’s because retirement benefits from defined-benefit pension plans are generally heavily weighted by your length of service. If you are considering changing jobs, staying where you are may have long-term advantages with regard to your pension benefits unless you will be earning substantially higher wages. Look at the following illustration that compares two people with identical salaries and years of service:
* Assumes the formula 1% multiplied by the highest 5 year earnings out of the last 10 years multiplied by years of service. Must complete 5 years of service to be entitled to a benefit. Janet has 40 years of service at Job 1. Stacie has 4 years at Job 1, 25 years at Job 2, and 11 years at Job 3. Both started earning $15,000 and received 4% increases each year.
As you can see, Janet accumulates a much larger benefit by staying in one job for an entire working career.
It may be that the combination of Social Security and your pension will not be enough to live on during retirement: you’ll also have to depend on your savings. If you’re fortunate, you’ve been contributing to a tax-deferred savings plan (such as 401(k), 403(b) or 457 plan). These are actually defined-contribution plans, but they work only if you have been contributing to the plan. You have the opportunity to save on a pre-tax basis, and your money grows tax-deferred.
At this point, you should be contributing the maximum pre-tax contribution to your plan. However, if you’re a highly compensated employee, generally earning over $120,000 in 2016 (same in 2015), your contributions may be limited. The calculation to determine contribution limits is based on your prior year’s (2015) earnings.
IMPORTANT NOTE: With a tax-deferred savings plan, you may be responsible for making the investment choices that affect your long-term performance. It’s important that you understand each of the available investment options, how they work, and which ones are most suitable for you. Your major investment concern now is to preserve principal; but you should also be concerned about growth.
If you want to contribute more than the pre-tax amount your plan permits, find out if your company savings plan contains a feature that allows you to make after-tax contributions that grow on a tax-deferred basis.
Beyond company plans, you may have also been contributing to an Individual Retirement Account (IRA); or, if you (or your spouse) have had self-employment income, you may have been saving in a Keogh, SEP, or SIMPLE (these plans can also be utilized by self-employed individuals and offered to employees of small businesses). There are also deferred annuities, in which your contributions grow tax-deferred.
There’s a lot to know in order to get the most out of these three legs. If you’re uninformed, you could end up with one leg too short.
NOT A DEPOSIT • NOT FDIC INSURED • NO BANK GUARANTEE • NOT FEDERAL GOVERNMENT AGENCY INSURED • MAY LOSE VALUEBack to Blog >