Make your pension contributions

“I was a fool! I didn’t contribute to the retirement plan my first 12 years in the job!” — former work colleague now approaching retirement

What if I told you that I’d contribute extra money to match what you save? Would you be interested? OK, let me add on a tax benefit. Interested now? Just to make it even more valuable, let’s add on the ability to invest in lower-cost investments that you wouldn’t normally be able to access. Does this further pique your interest? I know my answer would have been YES since the first question.

This is what most company-based retirement plans offer. In the US, the main defined contribution retirement account is the 401(k). Incredibly, only 41% of employees eligible to contribute to such plans do so (Does the Average American Have a 401(k)?). I’ve never understood why someone would not contribute to their pension plan given all these benefits, so today’s post is convince you to be one of those contributors. While the participation number I’ve quoted above is for the 401(k), most other pension plans offer similar types of benefits which are definitely worthy of your contributions.

Here are the key benefits to most pensions. Now, there are many different kinds of pension plans. For my examples, I’m going to focus mainly on the 401(k) given how common it is in the US:

Free money!

The money you contribute to your pension is typically topped up by your employer to get to your full pension contribution. This is “free” money for you! I put the word “free” in quotations as, in my view, this is part of your compensation. However, in most retirement plans, you only get that compensation if you make a contribution to your pension. If you don’t contribute, you are losing out on that money.

401(k) plans on average provided a match of about 4.5% of an employees salary in 2021 (How America Saves 2021). Other pensions, in particular defined benefit plans (see below for more details), provide even higher top up payments for employees’ pensions.

Risk shifting

Investing is risky. Any money you invest can be lost, or you can have very low returns. There’s no guarantee that your investment will be successful.

For a small subset of pensions, called defined-benefit pensions, a very meaningful benefit is that you are able to offset your investment risk to your employer.

“A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service — for example, 1 percent of average salary for the last 5 years of employment for every year of service with an employer” — Types of Retirement Plans

Because there is a specified monthly benefit which the pension is obligated to pay out, you are protected from investment risk. If the pension’s investments don’t earn enough money to meet the required payment, the employer is required to put in additional funds. So, with a defined-benefit pension, you know exactly how much money you will get each month.

Unfortunately, defined benefit pensions are becoming rarer as time passes as employers naturally don’t want to bear the investment risk. There is also always the risk that your employer goes bankrupt and cannot pay out promised pensions. However, most countries have insurance schemes for pensions so there is a level of government protection just in case.

Tax advantages

Pensions generally are tax advantaged. As mentioned above, there are many different types of pensions and tax laws differ across countries so not all pensions get every type of tax advantage — you should do the research for your particular pension opportunity to confirm what advantages you get. The advantages described below are for 401(k)s:

• Tax benefit for contribution: Depending on what type of 401(k) you contribute to, the monies you contribute will be subtracted from your current income so you don’t pay taxes on them. Therefore, every dollar you contribute actually costs you less than a dollar in after-tax income. This is the case for the traditional 401(k); if you contribute to a Roth 401(k), your contributions are taxed
• Deferred or no taxation on earnings: Investment earnings in 401(k) are not taxed while they remain in the pension. This enables them to grow faster as you compound earnings on a larger non-taxed base. Earnings are only taxed when they are paid out to you upon retirement in the case of the traditional 401(k)s when you are most likely to be in a lower tax bracket. For Roth 401(k)s, earnings are not taxed at all

In addition to the above, if you are in a defined-benefit plan, many countries tax only a portion or sometimes even none of your monthly benefit.

Investing options you may not have access to by yourself with lower investing costs

Pensions typically have many members across whose retirement portfolios there is a meaningful amount of money. This size gives them negotiating leverage with investment firms who are all trying to win the pensions’ business and the long-term fees that they bring.

To win pensions’ business, investment firms often offer investments which you don’t have access to as a retail investor. These investments generally provide improved investment results:

• Different classes of funds with lower fees than their sister funds offered to retail investors
• Investment opportunities not available to retail investors

Built in Automatic Investing

As I mentioned in my article Why and How to Save, a great way to save money is to automate it. Pension contributions are made directly from your paycheck so the process is fully automated for you. In addition, because you never actually see the money, you don’t really miss it and feel like you’re sacrificing your quality of life for long-term savings.

The contributions you make also benefit from a process called Dollar Cost Averaging where you “invest your money in equal portions, at regular intervals, regardless of the ups and downs in the market” (The Pros and Cons of Dollar-Cost Averaging). DCA helps you take emotions out of your investing and as “you buy more shares of an investment when the share price is low and fewer shares when the share price is high. This can result in paying a lower average price per share over time.” (The Pros and Cons of Dollar-Cost Averaging).

Growing flexibility

The only real downside of investing in your pension is that you are locking up your money until you reach retirement age. In times of real emergency, where you need access to those monies, you have limited options. However, pension plans are becoming more flexible and, in the case of 401(k)s, many plans now offer the ability to borrow from your invested funds. There are some hoops to get to those monies and potential costs if you don’t repay them (for more details, see the IRS publication: Considering a loan from your 401(k) plan?), but the ability to access those funds in emergencies does exist.

This completes today’s post on making your pension contributions. The practical steps you can start taking from today’s post are:

• Make sure to contribute to your pension: Sign up as soon as your employer allows you to start contributing to your pension to get free money, tax benefits, the ability to access lower-cost investments and automated savings with the benefit of dollar-cost averaging
• Ensure that your contribution maximizes any pension match: Employers let you choose the level of contribution you make to your pension. Sign up for at least the amount which maximizes the match that the company makes. This way you don’t leave any money on the table

Thank you again for joining me on my journey to build financial literacy for young adults and their families. Please share any comments or questions that you have in the comments section. If you are interested in reading more of my posts, please access my author page (https://vocal.media/authors/sudhir-sahay) where you can see all the posts I’ve published. Also, if there are any topics you’re interested in my broaching in future posts, please let me know. In addition to the comments section, I can be reached at [email protected].