Saving for Retirement: Employer-Based Plans

One of the keys to successful retirement planning is to make full use of tax-advantaged investment accounts.

Most working people have a retirement savings plan offered by their employer. However, more than 60% of employees fail to take full advantage of their retirement plans, which is akin to throwing money out the window.

What follows is a simple explanation of how these plans work and why you should take full advantage of them.

There are two basic types of retirement plans offered by employers: defined benefit and defined contribution.

A defined benefit plan is a traditional pension plan. You put in your 30 years on the job and you can retire with a guaranteed pension for the rest of your life. Your annual pension is calculated using a formula, such as 60% of your average salary over the last three years of employment. The critical feature of a defined benefit plan is that your employer bears the risk. As long as the company remains solvent, your pension is guaranteed.

With a defined contribution plan, you are allowed to invest a specified amount of pre-tax dollars each year in a tax-deferred account. In some cases, your employer will make matching contributions. There are no guarantees regarding the amount of money that will be available when you retire. It all depends on how much you put in and how well your investments perform. In other words, you bear the risk - not your company.

Examples of defined contribution plans include 401(k), 403(b), profit sharing plans, and a variety of others. In a standard 401(k) plan, you select from a menu of mutual funds. Profit sharing and money purchase plans allow more flexibility. With these plans, you can invest in anything from government bonds to pork bellies. Of course, there are no guarantees about future results.

Why is it so important to participate in retirement savings plans? For one thing, it ensures that you are putting some money away for your retirement. In addition, the money you invest will grow much faster in a tax-advantaged account. With compounding, a tax-deferred retirement account will grow to about twice the size of a similar taxable investment over 30 years.

The danger with defined contribution plans is that they are self-directed. If you do a poor job investing your money, you could get caught short at retirement. For this reason, we recommend obtaining high quality professional advice to construct a broadly diversified portfolio suited to your investment goals and risk tolerance. With this approach, you will avoid the recent fate of Enron employees who saw their retirement savings evaporate along with the company's stock price.

To summarize, we strongly recommend that you invest the maximum amount each year in your company retirement plan. You are also likely to benefit from good professional advice about how to maximize your long-term returns at a risk level you can live with comfortably.

May 1, 2002

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