The Bogleheads' Guide to Retirement Planning (15 page)

Career members of the military service are covered under two slightly different military retirement systems. You must serve at least 20 years in the military to become eligible for military retirement. The high-three system pays 2.5 percent of the highest three-year basic pay for each year of service. The REDUX system pays 2 percent for the first 20 years and 3.5 percent for years between 20 and 30, with the benefits adjusted back to the high-three system at age 62. In exchange for lower benefits before age 62 and a lower COLA rate, members who chose the REDUX system receive a $30,000 career status bonus at their 15th year of service (think of it as an advance from the pension). You can find more information about military pension benefits online at
www.defenselink.mil.
.

According the Census Bureau, as of 2006, there were 2,654 state and local government retirement systems covering more than 18 million members and 7.3 million beneficiaries receiving monthly benefits. About 90 percent of these members and beneficiaries belonged to 221 state systems. Suffice it to say that each system has its own complex rules. Within each system, there can be hundreds of participating agencies using different benefit formulas. For example, California Public Employees’ Retirement System (CalPERS) is one of the largest state employee retirement systems in the United States. It covered 1.6 million employees, retirees, and their families in 2008. Within CalPERS, there are 13 different benefit formulas and 57 optional contract provisions. Some employees receive 3 percent of their final pay for each year of their service at age 50. Other employees receive only 1.25 percent of their final pay for each year of service at age 65. It’s impossible to generalize the benefits under state or local plans. If you are a member of a state or local retirement system, you should find out exactly how your plan works.

If you are fortunate enough to be covered by a defined benefit plan, it’s important to know exactly how you qualify for benefits so you do not lose what is due to you. If you work in the private sector, your employer is required by ERISA to provide you with a document called the summary plan description (SPD). The SPD is an important document that specifies in plain English how you accrue benefits, when you become vested, and how you will receive benefits under the plan. If you didn’t keep the SPD your employer gave you when you first joined the company, you should ask for a new copy now and put it in your files.

Every time the plan is amended, your employer is required to send you another document, the summary of material modifications (SMM). File the SMMs together with the SPD. Read the SPD and SMMs, and try to understand what they say. Make an appointment with a human resources representative if you do not understand the documents, and ask them to explain the forms to you. If you work in the public sector, your employer usually has similar handbooks that describe the plan. Make sure you understand how the plan works.

After reviewing your SPD or benefits handbook, try to answer at least these questions:

If you find yourself unable to answer these questions, you will have to read your plan materials again or chat with a human resources person. Write those answers down. They will help you plan your retirement.

Your employer may also send you annual benefits statements. These statements show you how much you’ve already accrued in benefits. Because your date of hire and any changes to your employment status or position may be factors for determining what your retirement benefits will be, be sure to verify and document the relevant dates. Save all your W-2s because your compensation history is used in the retirement benefits calculation. Over the course of many years, it is possible that your employment or compensation records were misplaced or recorded incorrectly. If you have your own records, it will be much easier to verify whether your benefits are calculated correctly.

If you are thinking of leaving your employer before you are eligible to receive retirement benefits, you should take into consideration your retirement plan’s vesting and benefit accrual schedule. If by staying a few more weeks or months, you can become vested in your pension benefit or accrue one more year of credited service, postponing your departure will mean a higher retirement benefit in the future. Because of the way benefits accrue in a defined benefit plan, leaving an employer when you are close to retirement will reduce your pension benefit by quite a bit. Make sure you take that into consideration when you make job change decisions.

If you are eligible for a deferred pension in the future from a former employer or from a divorced or deceased spouse’s employer, be sure to keep the employer’s contact address and phone number. Due to company mergers and acquisitions or perhaps even bankruptcy, it’s likely the company’s contact information will change. When you move, you should also notify the company. You’ve earned the pension. However small it may be, it’s yours. Don’t lose it.

If you are a participant in a defined benefit pension plan, congratulations! You have a valuable benefit many Americans do not have. Hopefully, you now have a better understanding of how a defined benefit pension plan works. More important, you should understand specifically how your plan works and what you can expect to receive when you retire.

A defined contribution plan provides an individual account for each participant. The benefit received at retirement is determined by the contributions over time, the total return of the assets, and the fees the plan imposes. Contributions to a defined contribution plan can be made by the employer, the employee, or both, depending on the type of plan.

The most important benefit of a defined contribution plan is that it is a tax-advantaged account. You typically have money deducted pretax directly from your paycheck, after Social Security and Medicare are taken out. When you eventually withdraw money from the plan in retirement, you owe income taxes on the full amount you receive. The exception is a Roth 401(k), where after-tax money was contributed.

Defined contribution plans include, but are not limited to, the following:

The 401(k), 403(b), and TSP plans are very similar. The 401(k) plans are usually offered by private business, 403(b) plans are offered to public education and nonprofit employees, and the thrift savings plan (TSP) is offered to federal government workers. The 401(k) plans, 403(b) plans, and TSP now have essentially identical contribution limits, withdrawal requirements, and other terms.

In a 401(k) plan, 403(b) plan, and TSP, employees select the funds they want to invest in from a list of options available in the plan. The employer may offer matching contributions for some or all of the employee’s contribution.

Table 6.1
lists the maximum contributions to defined contribution plans in 2009. These figures may adjust each year because of tax law changes and inflation. Check with your tax adviser to ensure you are not taking more than the maximum benefit.

Source:
U.S. Internal Revenue Service

The IRS limits for 401(k)-type plans allow contributions up to $16,500 ($22,000 if you’re over 49) every year in a tax-deferred account. (That’s the amount for 2009; it increases in $500 increments to match inflation.) This allows investment gains to compound year after year, and you pay taxes only when you withdraw the money.

Many employers offer matching funds for some amount of your investment, such as 50 percent of the first 4 percent of your salary that you contribute. The matches often vest over three or four years to encourage you not to switch jobs. Because it is essentially free money, 401(k) matching is one of the best investment options anywhere.

Although you’re limited to employee 401(k) contributions of $16,500, your total defined contribution plan limits are $49,000 ($54,500 if you’re over 49). You can reach this higher figure either with a 401(k) plan that offers a 200 percent match, by investing in a 457 plan as well as a 401(k), or through a defined contribution plan that also allows employer contributions.

If you plan to contribute the IRS maximum ($16,500 in 2009, or $22,000 if you are older than 49) to your 401(k) and you receive a match, be careful not to exceed the annual contribution limit before your final pay period, which could cause you to miss out on part of the match. Many employers pay matching funds spread out in all pay periods. Stopping your contributions by reaching the limit early in the year also stops matching contributions. As such, you can subtract the amount you’ve already contributed from $16,500 and divide the balance by the number of pay periods you have left in the year. This will maximize your annual contribution without forgoing a match.

401(k)-type plans are always fully funded, which means you own the money as soon as it is deposited in your account. Your employer cannot decide to take it back. By contrast, with defined benefit pension plans, an employer’s bankruptcy can affect your portion of the account even decades after your retirement. That can be devastating. When United Airlines went into Chapter 11 bankruptcy in 2005, some pilots and their widows had their payments cut by as much as 75 percent.

In 401(k)-type plans the employer is not responsible for funding and selecting investments in your account. You are. The responsibility lies with you. Employers can make the process much easier by offering low-cost funds and selecting prudent automatic investments for new employees who are not familiar with investment principles (see the following).

One of the great benefits of a 401(k)-type plan is your ability to take your money with you when you leave a company. Compared with traditional pension plans, 401(k)s are a better fit for the modern workplace, where most people will have 5 or 10 different employers over a career. With a 401(k), each time you leave a company, you can roll over your retirement account into an individual retirement account with no tax consequences. Unfortunately, a large number of 401(k) plans have truly atrocious investment options, with fees 10 or even 20 times higher than is reasonable. But even those plans are generally worth investing in, especially if you get a company match. They allow you to build up the tax-advantaged accounts that will dramatically improve your returns over the subsequent decades by enabling you to defer taxes or have your investments grow tax-free. Every time you switch jobs, you should generally roll over the full balance of the 401(k) into an IRA, as described in Chapter 4.