A 401(k) plan isn’t a pension plan. Although both plans are retirement plans, only a pension plan is designed to provide a known monthly income stream which is generally payable for life.
Defined Benefit vs. Defined Contribution
A pension plan is designed to provide employees with a specified, or defined, benefit at retirement age. The amount of the benefit is actuarially calculated using salary, age, years of service, and an assumed rate of return for the plan.
Typically, employers make 100% of the contributions, which are mandatory, to a pension plan. Employees, or plan participants, receive a fixed monthly lifetime benefit with surviving spouses receiving 50% to 100% of monthly payments for the rest of their life.
The focus of a 401(k) plan, on the other hand, is on contributions, not benefits. Unlike a pension plan which is generally funded entirely by mandatory employer contributions, employees are responsible for making the lion’s share of contributions to 401(k) plans.
401(k) Plan Constraints
There are a number of IRS- and employer-imposed constraints in a typical 401(k) plan that make it difficult to accumulate funds that can be easily converted into an income stream to meet participants’ retirement needs. These include contribution limits, lack of Roth option, insufficient employer matching, limitation of investment choices, investment management, and unavailability of fixed income annuities.
Participants are allowed to contribute up to 100% of their salary to a 401(k) plan with a maximum allowable annual contribution of $18,000 or $24,000 if 50 or older.
Including employer contributions, there’s an overall contribution limit of $54,000 to a 401(k) plan. This limit generally only comes into play with individual, or solo, 401(k) plans.
Lack of Roth Option
100% of contributions to a traditional 401(k) plan are deductible on a pre-tax basis from an employee’s salary or self-employed individual’s gross income. The flip side is that withdrawals are fully taxable.
An increasingly available alternative to a traditional 401(k) is a Roth 401(k) option. While contributions to a Roth 401(k) aren’t deductible, withdrawals are nontaxable. Depending upon several variables, contributions to a Roth 401(k) plan can result in greater after-tax retirement withdrawals than a traditional 401(k).
Insufficient Employer Matching
Although employers can match a portion of employees’ 401(k) plan contributions, this either often isn’t done or isn’t very much. According to the Bureau of Labor Statistics 2015 National Compensation Survey, of the 56% of employers who offer a 401(k) plan, the match is 0% for 49%. While 41% match a percentage of employee contributions between 0 to 6% of salary, the average is a 3% match.
Limitation of Investment Choices
Most 401(k) plans limit their investment choices to mutual funds. While many plans offer dozens of funds, options within individual investment categories may be limited. This can potentially increase the investment risk associated with investment categories that aren’t well represented.
Unlike defined benefit pension plans which are managed professionally, 401(k) plan participants are responsible for selecting and allocating their contributions between investment choices offered within their plan.
Participants are also responsible for ongoing investment management. This includes periodic performances reviews and making changes to individual investments and allocation of current investments and future contributions. This can be problematic unless an employee has investment management experience or engages the services of a professional investment advisor.
Unavailability of Fixed Income Annuities
The availability of a natural retirement planning vehicle, deferred fixed income annuities, is currently limited in most 401(k) plans today. Deferred fixed income annuities provide known sustainable lifetime income beginning at a specified future age just like a pension. Nontaxable lifetime income payable to an individual and his spouse is possible to the extent that a fixed income annuity is offered in a Roth 401(k) plan.
401(k) Plan Requires Coordination with a Retirement Income Plan
Let’s face it. It’s a lot easier doing retirement planning if you know that you’re going to receive a known monthly lifetime income stream in addition to Social Security beginning at a specified age than if this isn’t the case.
Given the fact that a 401(k) plan isn’t designed to produce a defined monthly lifetime benefit beginning at a certain date, coordination with a retirement income plan is essential. Your plan needs to include a calculation of the projected annual income required from your 401(k) plan to meet your retirement needs that isn’t projected to be provided by other sources of income. That’s the easy part.
Now try figuring out the amount of contributions you need to make each pay period to your traditional vs. Roth 401(k) plan between now and your projected retirement date, the investments you should choose, and the allocation of contributions between various investments with an assumed employer match to accumulate a specified plan value at retirement that will enable you to produce the projected annual income needed from your plan to meet your retirement needs assuming that your plan doesn’t offer deferred fixed income annuities as one of the investment choices.
Forget about the possibility of having multiple 401(k) plans, borrowing from your plans, or taking premature withdrawals from them. A 401(k) plan definitely isn’t a pension plan!
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.