Few people refer to their 401(k) as a “defined contribution plan.” In fact, many people appear to perceive a 401(k) or for that matter a 403(b) plan as an “investment plan.” Many employers view their 401(k) plan as an optional, take-it-or-leave-it employee benefit.
Historically, people who went into teaching and other public sector careers received a pension (defined benefit plan) that was totally managed by someone else. A pension was one of the reasons they chose that career.
Defined contribution versus defined employee benefit
The terms defined contribution plan and defined benefit plan may be a bit foreign to you. A defined contribution plan is a bit of a misnomer. It simply defines the maximum amount you can save or put into the plan. It also promises no benefit in the future! Contrast that with a defined-benefit plan that does specify a future benefit.
In this case, the risk for the future benefit is on the employer. Employers typically hire an actuary to help them calculate how much needs to be saved. They will also determine what rates of return need to be achieved. It’s all about making good on that future promise of payment to an employee.
More often than not, another firm is then hired to help manage the rates of return that the actuary suggests. Based on the actual investment results adjustments to the savings rate may be needed.
Creating a defined benefit (pension) from a defined contribution plan
If you are like some people I’ve talked with, you may also have accumulated a significantly defined contribution balance. I think the best way to approach creating your own pension or ongoing income stream is to think of how much money you would like to have monthly when you retire.
Let’s say you want to live on $50,000 per year upon retiring. If you accumulated a balance of $1 million you would have 20 years of withdrawing $50,000. However, that does not factor in the reality that prices are likely to continue to increase over time and your out-of-pocket expenses for health care costs are likely to rise. For example, if you factor in say 4% inflation in the second year of your retirement you would need $52,000 and so on over the years.
You can easily see that you will run out of money after 20 years. This “keeping up with inflation” may try a few can be batty as you now subject your nest egg to the ups and downs of stock and bond markets. How much risk-adjusted return do you need to subject yourself to? How should you do it?
Alternatively, you could deposit the money with an insurance company that has a fixed, single premium immediate annuity. While your million does not get you $50,000 per year, it would not run out of money if you picked the life annuity feature. Each insurance company determines how much it would payout based on the amount deposited. This is the essence of what you get with a pension.
You and your employer would make deposits into a fund from which it would pay benefits. The money was traditionally pooled with everyone who was making that same deposit. In this case, you get to benefit from not only any returns that the insurance company gets from investing your money but also from any unused monies by those who made deposits and died before exhausting the pool of money. This is a benefit of electing an annuity for retirement income versus simply depending on investment returns and controlling you’re spending.
Tieing in the idea of a defined contribution plan as an employee benefit
A “defined contribution” plan (not a “defined benefit” plan) allows you to choose how you want to turn your savings into income. If you have beneficiaries who would benefit from your savings, you can choose to live on less to leave money to them. If you’re single, you may want a life annuity. An annuity allows you to not worry about running out of money during your lifetime.
Account for inflation by either adding a cost-of-living adjustment or with a “side investment account” designed for that purpose.
You can also create a hybrid strategy. This allows you to annuitize some and leave the rest to your beneficiaries in a separate account. You can account for your needs, mortgage or rent, groceries, health care, etc. by what you deposit into the annuity. This investment account can then provide for your needs and wishes, beyond your necessities.
All of this requires some thoughtful calculations and questioning of certain assumptions. A seasoned certified financial planner, who is familiar with these tactics, is the best person to handle all of this.