Due to 2012’s Proposition B being overturned, there is a lot of talk concerning how this outcome will affect the 5,400 employees hired between 2012 and 2021 and the difference between a 401(k) and a pension plan. Ultimately, we’re currently not sure what choice the City will make concerning employees and their pension. However, we just want to make sure the record is straight on the difference between a defined benefit plan and a defined contribution plan.
Pension - Defined Benefit Plan
Essentially, a pension is a retirement fund that is managed by your employer. It’s labeled as a defined benefit plan because the plan is a “defined benefit” from your job in the same way insurance is.
With a pension plan, the employee assumes none of the risks, in turn, the risk is entirely on the employer. Pension plans are funded through a trust that is managed by an investment professional. You pay a portion of your paycheck into that trust monthly, this portion is called the “member contribution rate” and it is usually determined by the age you were when you were hired.
Calculating your Pension
When you retire, you’ll receive monthly payouts based on your pension. The general formula SDCERs uses for determining your pension is as follows:
(Age Factor) x (Service Credit) x (Final Compensation)
This formula might differ depending on your union or your hire date, contact your employer for specifics. That being said, all of the formulas use the same variables listed above, so here's a quick breakdown of what each of these variables means:
-Age Factor: This is determined based on when you retire and your job. The rate can be anything between 2-3%.
-Service Credit: This mostly refers to the number of years you’ve worked for your employer. This number is proportionally adjusted if you work part-time. There are some unique instances of receiving extra service credit, you will know if this applies to you.
-Final Compensation: The average dollar amount taken from either your highest year-long salary or the average of your three highest years of base salary. This value does not include bonuses or overtime.
There is an additional adjustment that you can choose, where you lower your monthly pension check, but if you pass away your spouse will receive contributions from your pension, click here to learn more about that.
Using this formula, you can calculate your pension for yourself or you can head to the SDCERs website and get an estimate of your pension by clicking here. Once you’re on the site, click the summary that applies to you and then scroll down to the bottom, from there you can log in to the member portal and calculate your pension.
Here’s an example: say you’ve worked for the city for 30 years and your three highest annual salaries were: $49,750; $50,000; and $50,250. And your retirement factor is 2%.
First, you’d average your salary to get your final compensation:
(49,750 + 50,000 + 50,250) divided by 3 = 50,000
Then, you’d multiply your retirement factor, service credit, and then your final compensation:
.02 x 30 x 50,000 = 30,000
That means your annual pension is $30,000, divide that by 12 and you’ll see that you’re receiving $2,500 a month.
Pension Pros and Cons
The only downside to pensions is that you have really no control over how much you put into one, get out of one, or what kind of investment choices you’re making. That means you can’t put more money into it when you’re doing well, or put less money into it when you’re in financial need. It also means you can’t borrow money from it like you can a 401(k). Pensions also aren’t inheritable. There are continuation benefits for spouses if you choose them, but that means you’ll receive a reduced pension. This also means that if you die prior to retiring, the pension will only pay a reduced portion to your spouse. As for the fact that you can’t make the investment choices yourself, well, depending on who you are, that might be a positive. Pensions are large trusts managed by investment professionals, meaning you can usually expect their returns to be relatively steady.
If you can clear the vesting period (for the city that’s 10 years) then you really can’t go wrong with a pension.
There is also DROP, which is a little complicated, so we’ll come back and write an article on that later. But if you’re interested, check out this article from SDCERs.
401(k)/IRA - Defined Contribution Plan
401(k)’s are investment accounts that are taken pretax (post-tax for IRAs) from your paycheck. 401(k)’s and IRAs are called defined contribution plans because you define your own contribution! Once money enters a 401(k) it remains in there until you retire. Many employers offer a matching program on 401(k)’s allowing you to essentially be “paid” for investing in your future.
401(k)s are pretty simple, you just put money in, and eventually, you’ll be able to take it out! There are some restrictions, for example, you can only contribute a maximum of $20,500 a year (as of 2022, this number will rise with inflation). Generally, when you set up a 401(k) you can decide if you want your assets to be invested aggressively or safely, depending on your risk tolerance. The other risk that comes with a 401(k) is if you outlive your savings. If you’re not saving enough, you’ll tap out of your 401(k) sooner than expected, but still, the plan is better than nothing and if you’re planning ahead, you should be alright.
401(k) Pros and Cons
Estimated returns on a 401(k) are around 8%, which is a large sum of money when you consider how long you’ll be paying into it. Additionally, you can bring your 401(k) to any employer, the same goes for most IRAs too! There is no vesting period required for a 401(k) either, meaning you’ll start seeing returns a few months after setting up your account. Additionally, a 401(k) is money that belongs to you, unlike a pension which essentially only guarantees a paycheck, the money in a 401(k) is tangible and inheritable.
But! 401(k)s don’t provide any support for inflation. They also require more active attention than a pension plan. It’s a lot harder to predict your retirement income with a 401(k) and as stated previously, you could outlive your savings.
One of the best parts about defined contribution plans like a 401(k) or an IRA is that you can set them up on your own outside of work. Meaning someone with a pension or a 401(k) could also have an IRA. They’d be taking a sizable chunk out of their paycheck, but that amount would set them up perfectly.
If you’re curious about your own financial status or what you should do in the context of your pension/401(k), or just your retirement plan in general, we suggest you talk to a certified financial advisor. Interested? Check out this article on the biggest mistakes when it comes to retirement planning, in it, we go over an easy way to find a financial planner!
https://news.sdpeba.org/most-common-retirement-mistakes-on-the-road-to-retirement
There is a lot to consider when retiring, but just know it’s never too late to start figuring these things out. The sooner you start planning the sooner you’ll be able to find peace of mind!
Interested in our other retirement articles? Check out the list below.
Estimating the Cost of Long-Term Care
How your Benefits Translate into Retirement
How do you keep an Income while Retired?