Are pensions a thing of the past ? Is there an alternative if we want to have a wealthy retirement?
Most twenty-somethings have never tasted the security of a pension plan and, unfortunately, are unlikely to do so in the future. So, what exactly are these mysterious pensions that many of our parents and grandparents rely on in their golden years?
This is the situation with private pensions, but what about social security and the money you are supposed to get from the government when you get old.
You probably won’t be getting much or even any benefit from the government or your company and that is why you will have to pay for your retirement yourself.
What is the definition of a pension?
A pension is essentially the same thing as a retirement plan. Pensions are divided into two categories.
A Defined Contribution Plan (DCP):
A defined contribution plan is a type of pension in which funds are contributed to an employee’s retirement plan by either the employee, the employer, or both.
Defined contribution plans, or 401Ks, are a type of retirement plan. These plans are based on the performance of the investments made within them.
Defined Benefit Plans (DBPs):
A defined benefit plan is what most people think of when they hear the word “pension.” These plans provide guaranteed automatic retirement payouts based on a formula that typically considers your salary and years of service.
The higher your automatic payouts are, the longer you work and the more you earn. At one point or another, most employers offered defined benefit plans. A defined benefit plan’s example is Social Security, which is a type of defined benefit plan.
The History of Pensions
Pensions have been the standard retirement plan for almost every employer for generations since post-World War II.
It may come as a surprise, but 401Ks were not invented until the early 1980s. Ironically, 401Ks were added to the IRS code to allow companies to provide additional retirement benefits to high-ranking executives beyond their defined pensions.
This was short-lived.
Most employers have switched from defined benefit pensions to 401(k)s over time. Employees were sold 401Ks as the hot new thing, giving them complete control over their investments.
In reality, they were often only minor cost savings compared to their defined benefit counterparts. The perfect storm for selling 401Ks over their elder relative was the appeal to American individualistic ambition combined with cost-cutting opportunities.
Why are pensions becoming obsolete?
Private pensions not respected. In the financial crisis of 2008, for example, a lot of companies that went bankrupt did not have money to pay for their employee’s pensions.
This caused severe panic among people set to retire or already retired as they weren’t going to get the money they deserved.
The hardest hit were the people already in retirement and found it extremely difficult to cope with their finances without their pension to support them.
Social Security is underfunded
Social Security is underfunded right now, and it is only estimated to happen worse. The new generation, the millennials, are expected to provide the pensions for baby boomers, which was the largest generation in the history of America.
Social security is expected to run out of money in 2034, according to current estimates.
Even if nothing is done about social security, projections show that the program will cover around 79 percent of its obligations through 2090. That is a funding issue that needs to be addressed. However, this does not imply that the program will fail.
What to do if you can’t rely on pensions?
The government has given other tax incentives for investing in retirement.
The options range from a 401(k), an IRA, a Roth IRA, a Roth 401(k), among other investments.
These investments are a great choice for supplementing your income for your retirement because of the possibility of social security running out.
You should invest in your retirement from the starting as you may not rely on your company or the government.
IRA: Individual Retirement Account
An individual retirement account (IRA) is a type of account that you can open specifically to save for retirement. ROTH IRA and Traditional IRA are the two types of IRA accounts.
IRAs give you the freedom to invest your money in whatever way you want. Stocks, mutual funds, bonds, and other assets are all options. You can open an IRA account with a bank or a broker, who will assist you with the process.
IRAs are only a type of investment, which means they provide you with certain benefits such as tax breaks on your investments. Still, they are not the same as the other types of investments discussed in this article.
Traditional IRAs allow you to put pre-tax money into your account. Still, you must pay taxes on withdrawals when you reach retirement age ( but usually at a lower tax rate). Many people will benefit from this because they will increase their contributions before paying taxes on their earnings.
Suppose you were on the fence about opening an IRA account and are now considering it. In that case, you should instead open a ROTH IRA account.
A ROTH IRA is the polar opposite of a Traditional IRA in that you can invest after-tax money in the account and keep the entire investment tax-free when you retire.
If you are in a lower tax bracket now than you will be when you retire, so you can pay your taxes now to lock in a lower tax rate than you will have when you retire.
While an IRA is an individual retirement account a 401K is a type of employer retirement account. A 401k plan is a tax-advantaged retirement account available to all working Americans. You can work for a large corporation or own your own business and still participate in a 401k plan.
The main advantage of a 401k is that it is employer-sponsored, which means that your employer is required to contribute a set amount to your account.
Up to a certain limit, your employer will match your 401k retirement investment. This can help you accelerate your portfolio, and you should always take advantage of your employer’s match.
401(k) plans typically only allow you to invest in investments that your employer deems appropriate. The most popular 401k investment option is mutual funds.
When you work for yourself, you have more freedom in terms of what you invest in.
Like an IRA, there are two types of 401ks. Traditional and Roth IRAs, which are essentially the same thing. The tax system is the only difference between the two.
Pensions may not be here for a long time, but you hopefully will be.
Don’t postpone retirement planning and start early so that you get full advantage of compounding interest. Even Albert Einstein considered compound interest as the eighth wonder of the word. Also, Benjamin Franklyn had the saying: “Money makes money. And the money that money makes, makes money.” That is why you have to start saving as soon in your life as possible.
The stock market is volatile in the short run but it is expected to bring very high returns in the very long run. I started saving with my first job in the US at IBM. I had no knowledge then of the stock market but my consoler at IBM convinced me to save in the stock market small caps and live the money in there as long as possible. 35 years later the money I saved over the years has grown to a very healthy amount – I was lucky because the stock market really zoomed up in the last decades and hopefully it will be the same thing to happen also in the future decades.
I personally kept most of my money in small caps and a smaller portion on S&P 500 which are as volatile as the market but, since, the basics of finance that requires diversification, I also invested in real estate which is not quite as volatile and brings a monthly income from rentals. People are living longer: an income from real estate will last till you own the real estate and at the same time the capital invested might appreciate ( about 3.5% per year in the US as an average)