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The ABCs of Employer Sponsored Retirement Plans

Retirement plans offered through your job come in all shapes and sizes. Understanding the details can almost feel like learning a foreign language. With all the IRS codes and lingo, the world of employer sponsored retirement plans resembles alphabet soup, especially if you’re unfamiliar with the types of retirement plans available. Most of us have probably heard the term “401(k)”, but this cannot be widely applied to all retirement plans offered through a job.

The reality is that the average person’s career is rarely linear. The days of sticking with one company over a 30 to 40 year time period and collecting a robust pension at retirement seem like a distant past.

 

The “Job-Hopping” Generation

Contrary to popular belief, it’s not just millennials this phrase applies to. Every previous generation has seen a job-hopping trend in their youth as they search for the right career path. 

A non-linear career zigs and zags which results in having access to multiple retirement plans. On top of that, some people may start out in the private sector and finish their career in the public sector, or vice versa. 

When that’s the case, retirement plans become even more confusing because of some important differences in government versus private sector benefits. 

Luckily, we’re here to help you sort through some of the differences and nuances of these plans! 

 

Defined Benefit vs Defined Contribution

First a quick primer on defined benefit versus defined contribution:

A defined benefit is a guaranteed or promised monthly stream of income provided to an employee in retirement (employer takes on investment risk).

A defined contribution does not provide a guarantee or promise as the benefit (account balance) grows based on the performance of underlying investments and a combination of defined (known) employer and employee contributions (employee takes on investment risk). 

 

The list below is not an exhaustive resource on all retirement plans, but it should be helpful in providing general info on some of the most common types of retirement plans employees have access to during their career. I address the following questions about each plan, but it’s important to seek out your plan’s specific details directly from your employer:

  1. What is it?
  2. Who is it for? 
  3. Who contributes to this plan?
  4. Is the benefit or the contribution defined? 
  5. How is income generated in retirement?

        Schedule a free meeting with me to find out how I can help! 

         

        “A” is for 401(a) Plan

        What is it?

        Some employers have a 401(a) set up called a “Money Purchase Plan”. Despite the requirement for mandatory employer contributions, this is in fact a type of defined contribution retirement plan.

        This plan is used in the public, non-profit, and education sectors. Investment decisions can either be “trustee-directed” meaning the plan’s committee or board manages the investment portfolios or “self-directed” meaning the employee can choose what funds they want to invest in based on a list of funds available in the plan.

        As with a 401(k) plan, the plan sponsor (employer) determines a vesting schedule and plan features.   

        Who is it for? 

        This type of plan is offered to employees of non-profit organizations and government entities, so you are unlikely to come across it if you work in the private sector.  

        Who contributes to this plan?

        401(a) plans require that the employer makes contributions on behalf of the employee. Employee contributions can be mandatory as well, but this is not the case with all 401(a) plans. Some plans permit voluntary employee contributions.

        And finally, some 401(a) plans may not allow for employee contributions at all but may be 100% employer funded! Review the summary plan description (SPD) and talk to your HR benefits team for more information. 

        Considerations for Social Security benefits

        Some 401(a) plans in the government sector are structured as a “social security replacement plan” where neither the employer or employee pay into social security.

        Taking money out of this type of plan can have a significant impact on an earned social security benefit and can trigger provisions known as the Windfall Elimination Provision (WEP) and the Government Pension Offset (GPO) for spousal/survivor social security benefits.

        Consult with your financial planner, HR benefits team and the Social Security Administration before making any type of withdrawal elections. 

        Is the benefit or the contribution defined? 

        This is a type of defined contribution plan.

        For example, a 401(a) plan may have a mandatory employer contribution of 10% of an employee’s pay and a mandatory employee contribution of 5%. In this case, we know that the contribution is defined as 15% total (combined employer and employee).

        What is unknown is how that benefit will grow over time as that will be based on the underlying performance of the investments in the account, similar to a 401(k). 

        How is income generated in retirement?

        The types of withdrawals available to employees in retirement is plan specific.

        Employees usually have the option to rollover their account to another qualified retirement account, take a lump sum distribution, set up “installment payments” on a monthly or quarterly basis or potentially rollover the balance into an annuity, depending on what the plan allows. 

        Note: The plan sponsor (employer) determines whether contributions to a 401(a) are made on an after tax or pre-tax basis, so always consult with your financial planner and CPA before making any type of withdrawal elections. 

         

        “B” is for 403(b)

        What is it?

        A 403(b) plan is a type of defined contribution benefit used in the non-profit and education sectors. Another name for this type of plan is a “tax-sheltered annuity”.

        Historically, 403(b) plan’s main investment options were annuities. That type of option comes with some ugly repercussions in the form of complexity, potential surrender charges and opportunity cost in the form of meager returns versus a comparable mutual fund. In some cases, employees have hundreds if not thousands of options to choose from – talk about paralysis by analysis!

        Fortunately, for the sake of simplicity and transparency, many of these plans have moved toward a more “open architecture” structure, where participants have access to a streamlined investment menu of lower cost mutual funds.

        The plan sponsor (employer) determines a vesting schedule and plan features, while the employee “self-directs” the investments based on a menu of options.    

        Who is it for? 

        This type of plan is used for employees of public schools and certain tax-exempt organizations. It’s a way for employees to save directly for retirement via paycheck deferrals based on a percentage of their choosing up to the annual IRS limits.  

        Who contributes to this plan?

        Depending on the plan’s design, employees are permitted to make voluntary elective contributions through their paycheck. Similar to a 401(k), the employer may choose to make matching contributions up to a certain amount, discretionary contributions, or mandatory contributions as dictated by the plan document.

        This type of plan may also allow for employees to make Roth contributions, but again, this is a plan specific feature. Always consult with your financial planner and HR benefits team to help you determine how the plan is designed and what type of contributions are permitted.  

        Is the benefit or the contribution defined? 

        This is a type of defined contribution plan. For example, a plan may have a matching employer contribution of 100% of an employee’s pay up to 3% and an employee may choose to contribute 10%. In this case, we know that the contribution is defined as 13% total (combined employer and employee).

        What is unknown is how that benefit will grow over time as that will be based on the underlying performance of the investments in the account, similar to a 401(k). 

        How is income generated in retirement?

        The types of withdrawals available to employees in retirement are plan specific, but typically employees have the option to rollover their account to another qualified retirement account, take a lump sum distribution, or set up “installment payments” on a monthly or quarterly basis.

        Employees may also be able to simply take “one time distributions” on an as needed basis, but ideally you would work with a financial planner to set up an income plan.  

        Note: Again, because this type of plan is notorious for historically offering employees highly complex, expensive annuity products it may be beneficial to confirm your investment options and strategy with your financial planner!  

         

        “C” is for Cash Balance Plans

        What is it?

        A cash balance plan is sometimes called a “hybrid” plan. In this plan, a defined benefit is provided for an employee in retirement. However, the benefit to the employee is described in terms more typical of a defined contribution plan.

        Simply put, a cash balance plan shows the defined benefit in terms of an individual account balance for a specific employee.    

        Who is it for? 

        The cash balance plan can be found in both the public and private sector and sometimes is the result of a large entity converting from a traditional defined benefit plan.

        This type of plan can be especially attractive to older business owners because of the higher contribution limits. In general, the age-based contribution limits can top well over $200,000 for an individual over 60! 

        Who contributes to this plan?

        A cash balance plan creates an individual account balance for an employee and grows based on two metrics which the employer makes contributions: (1) an annual “pay credit” based on an employee’s compensation and (2) an “interest credit” that’s typically based on a fixed rate or tied to an index, such as the 30-year Treasury yield.

        The underlying investments in the plan do not directly impact the employee’s account balance, so the employer effectively takes on the investment risk.

        Is the benefit or the contribution defined?

        Unlike a traditional defined benefit plan, a cash balance plan is required to state an employee’s benefit in terms of an individual account balance. It utilizes components of both a DB and DC plan structure. 

        How is income generated in retirement?

        The beauty of the “hybrid” defined benefit/defined contribution plan is that when the employee is eligible to begin receiving their retirement benefit, they have the option of simply annuitizing their individual account balance based on the plan’s provisions or they may choose to take a lump sum payment and/or roll the balance over to another qualified retirement account.

        For example, an employee may reach a target retirement date with $150,000 in their cash balance plan. At this point, they could choose to annuitize the balance and receive lifetime payments or choose to take the lump sum/rollover option. 

        Note: This is general information as cash balance plans can have very specific rules around vesting, crediting rates, eligibility, etc. Always consult with your financial planner and HR benefits team before making any type of withdrawal elections. 

         

        “D” is for Defined Benefit Plan

        What is it?

        A defined benefit plan is relatively simple from an employee standpoint as it’s just that – a benefit provided to an employee based on a fixed formula. This formula is usually a component of years of service, age, and a benefit multiplier.

        While how to obtain the optimal benefit can be simple for an employee to understand (i.e. work 25 years and retire at age 55), these can be complex and costly plans for an employer to implement.

        Because the investment risk is on the employer versus employee (the employee gets a benefit no matter what the underlying investments do, assuming the plan is solvent) and given the increased mobility of the global workforce, this traditional type of retirement plan has become a less common benefit offering over time. 

        Who is it for? 

        A defined benefit plan is effectively an income replacement for retired employees that have reached a combination of years of service and age.

        For example, if a plan has a “rule of 90”, that would indicate an employee is eligible for an “unreduced” monthly payout at retirement, assuming their age + years of service = 90 or greater (i.e. Age 55 + 35 years of service).

        As the workforce becomes more mobile and employees less likely to spend their entire careers at the same company, defined benefit plans are less common today versus the now more prevalent and less expensive defined contribution plans. 

        Who contributes to this plan?

        Typically, this type of plan is funded entirely by the employer. In some cases, employees may be able to “buy in” to a defined benefit plan.

        For example, a newly hired police officer may be able to use some of their retirement funds from a previous qualified plan to “buy years of service” in the new city’s defined benefit plan.

        The employer is responsible for managing (or outsourcing to an advisor) the pool of assets in an investment portfolio out of which the benefits will be paid to retirees. Defined benefit plans are unique and will have specific designs, so it’s important to confirm the details of your plan directly with your employer. 

        Is the benefit or the contribution defined? 

        The benefit is defined as the employee gets a guaranteed stream of income the rest of their life. 

        How is income generated in retirement?

        The employee receives a guaranteed stream of income the rest of their life and/or a spouse if different distribution options are built into the plan.

        Again, always confirm with your employer and work with your financial planner and HR benefits team before you make any distribution decisions!

         

        “E” is for Employee Stock Ownership Plan (ESOP)

        What is it?

        An employee stock ownership plan plan (ESOP) offers employees shares in the company. This type of qualified defined contribution plan is used for privately held companies.

        This plan is not to be confused with an Employee Stock Purchase Program (ESPP) which is commonly used in publicly traded companies and offers employees the opportunity to purchase discounted stock in the company with after tax dollars. 

        Who is it for? 

        An ESOP can be beneficial as a retention tool and encourages employee engagement in the growth prospects of the company given they have “skin in the game”. It’s usually tied to some kind of vesting schedule where a portion of shares in the company are granted to the employee each year.

        It can also be a valuable tool for business owners that want to maintain their company’s culture, leave a legacy, and reward the employees that have helped build the company. 

        Who contributes to this plan?

        The employer makes tax-deductible contributions in trust to make shares of the company available which can in turn be granted to employees. The employee is usually granted shares subject to a vesting schedule, depending on how the ESOP is structured.

        Is the benefit or the contribution defined? 

        An ESOP is a type of defined contribution plan in which the employee is granted stock ownership via shares in the company, the value of which can fluctuate over time. The shares the employee is entitled to must vest based on a specific “cliff” or “graded” schedule, similar to other retirement plan vesting schedules.

        For example, an employee at an engineering company may have the right to 10 shares per year over the course of a five year vesting schedule. When the employee leaves the company, they would receive cash based on the value of 50 shares (10 shares/year x 5 years), assuming they were with the company long enough to be fully vested.

        This type of qualified plan is typically offered in combination with a core retirement plan benefit, such as a 401(k), and can be designed to include alternative ways for employees to obtain ownership. It’s important to review the details of an ESOP plan with your financial planner and benefits team to understand all the implications. 

        How is income generated in retirement?

        When an employee leaves the company or decides to retire, the company will purchase the shares in exchange for cash to the employee, either in a lump sum or equal periodic payments. 

        Note: Selling these shares are typically subject to capital gains taxes, although there are opportunities for tax deferral. Always confirm with your financial planner or CPA as these plans are employer-specific and understanding all the tax implications of granting and sales is vital!  

         

        “K” is for 401(k) 

        There’s no way I could forget to mention this one! 

        What is it?

        Most people are familiar with or have at least heard of a 401(k) plan. Depending on the plan’s design, employees are permitted to make voluntary elective contributions through their paycheck. Normally, the employer has some kind of match schedule in place to boost employee savings as an added advantage.

        While some 401(k)’s are loaded with high expense and complex investment options, many 401(k) plans have fortunately trended toward simplicity and transparency of investment offerings for the employee. Most plans have moved toward an “open architecture” structure, where participants have access to a streamlined investment menu of lower cost mutual funds.

        The plan sponsor (employer) determines a vesting schedule (“cliff” or “graded”)  and plan features, while the employee “self-directs” the investments based on a menu of options.   

        Who is it for? 

        This is a very common type of retirement benefit found in the private sector. It’s a way for employees to save directly for retirement via paycheck deferrals based on a percentage of their pay up to the annual IRS limits.     

        Who contributes to this plan?

        Employees are permitted to make voluntary elective contributions based on a percentage of compensation through their paycheck. Similar to a 403(b), the employer makes matching contributions up to a certain percentage, discretionary contributions, or in some cases, mandatory contributions.

        The plan may also permit employee after-tax and/or Roth contributions, but again, this is a plan specific feature. You can always consult with your financial planner to help you determine how your plan is designed and what type of contributions are available. 

        Is the benefit or the contribution defined? 

        This is perhaps the most common and well known type of defined contribution plan. The final benefit (account balance) for the employee is dependent on the savings and investment rate.

        For example, a plan may have a matching employer contribution of 100% of an employee’s pay up to 3% and an employee may choose to contribute 10%. In this case, we know that the contribution is defined as 13% total (combined employer and employee).

        What is unknown is how that benefit will grow over time as that will be based on the underlying performance of the investments in the account, similar to a 401(a) or 403(b). 

        How is income generated in retirement?

        The types of withdrawals available to employees in retirement are plan specific, but typically employees have the option to rollover their account to another qualified retirement account, take a lump sum distribution, or set up “installment payments” on a monthly or quarterly basis.

        Employees may also be able to simply take one-time distributions on an as needed basis, but ideally you would work with a financial planner to set up an income plan.  

         

        Summary

        Once again, this list is by no means exhaustive, nor does it cover all the complexities and specifics of these plans. This is simply general information on some of the most common employer sponsored plans you might come across during your career. 

        There are contribution limits you should be familiar with as an employee set by the IRS for these different plan types: Retirement Topics – Contributions

        When looking at your retirement portfolio, people are often hyper-focused on underlying investment performance (i.e. “My 401(k) returned 50% last year!”). 

        However, what you should be thinking about is how my retirement plan is DESIGNED (i.e. Roth/after tax contributions) and what’s the best way to optimize my SAVINGS rate!  

        Navigating these employer benefits can be overwhelming, but the tools are in place to help you successfully save for a financially independent retirement. 

        You can always work with your financial planner to help you decipher these different types of retirement plans. We want to make sure that you are taking full advantage of your retirement benefits, no matter what type your current employer offers or whether you work in the private or public sector! 

        Schedule a free meeting with me to find out how I can help! 

         

        Before you take on any investment or retirement strategy, it is vital that you seek out proper investment and tax advice beforehand. Investment performance is never guaranteed and investments may lose some or all of their value. On top of that, there may be severe tax consequences if withdrawals are taken improperly and can have a significant impact on your portfolio and retirement. Although we provide Investment Advice and Personal Financial Planning Services, we at MWM do not provide tax advice and any tax advice should be rendered by a licensed tax professional such as a CPA. 

        401(a) plan, 401(k) plan, 403(b) plan, cash balance plan, Certified Financial Planner, defined benefit plan, defined contribution plan, Financial Literacy, Kenny Senour CFP®, Retirement, retirement plans


        Kenny Senour, CFP®

        I am a Certified Financial Planner™ professional with Millennial Wealth Management, a fee-only registered investment advisor in Colorado. We educate and advise millennials and their families in the Denver and Boulder area, as well as other states virtually. As a millennial, I understand the financial choices our generation is faced with, from navigating your first home purchase or tackling student loans. My mission is to help our generation stop worrying about money.

        Copyright Millennial Wealth Management, 2020.

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