In the realm of personal finance, one of the first pieces of advice you’ll hear is to take advantage of your company’s’ 401(k) match. This assumes two things. First, that you work in a traditional corporate environment that offers a 401(k) with a match. Second, it assumes you know what that what a 401(k) is.

A 401(k) is a type of retirement savings plan, but let’s back up and have a bit of history on retirement planning.

Centuries ago, back in the 1960’s, corporate life looked very different than it does today. The expectation was that a man would join a company right after college and stay with that same company for his whole career. He would be the primary breadwinner in his family, so when he retired, the family needed some sort of contingency plan in order to have money. Presumably his 2.5 children would already have gone to college, so he would just be supporting himself and his wife after retirement. This is where pensions came from. The idea of pensions is that since you dedicated your entire career to one company, that company would take care of you after you retire. The company wouldn’t give you a full amount of pay since you’re no longer working, but they’d give you a portion of it. This portion is based on either your final year’s salary before you retire (if you’re lucky), or an average of your salary over time, and can be based on a variety of factors including how long you worked for a company. This is called a defined benefit plan, because the amount of money you get in retirement, your “benefit”, is a set amount.

Pensions require companies to have the money to continue to pay you once you’ve retired. They have to estimate how much they’ll owe each employee, how long you’ll live for, etc. They also have to choose to save the correct amount of money, rather than investing this money in other business endeavors. In short… pensions fail. They fail because the company is no longer in business once an employee is retired and expecting to receive pension payments, and because the pension accounts are “underfunded,” meaning the company doesn’t have enough to pay out what they owe. Also, people are living longer than companies expected them to when they were determining how much money to save. In 1974¹, the government launched the Pension Benefit Guaranty Corporation (PBGC). This means that the government … as in the taxpayers… will make pension payments if a company can not. For the individual, the payments they’ll receive the PBGC are a fraction of what they were expecting to receive from their corporation.

This system clearly does not work on a large scale. Today, pensions still exist in the US, mostly for government employees. As of 2018, public pension funds are underfunded by $4.4 Trillion Dollars².

$4.4 Trillion Dollars that employees expecting to get in retirement, but won’t. They can’t, the money isn’t there. The government didn’t save enough or invest well enough to pay its debts. The only place they can get the money is by pulling it from other places and raising taxes.

$4.4 Trillion Dollars. That T is not a typo.

I don’t know why more people aren’t upset about this.

So, the basic difference between a pension plan and a 401(k), is that a 401(k) puts the power back in your hands, the individual, to plan for retirement, but it means you bear the responsibility as well. Over the past couple of years I’ve started to hear some left leaning / liberal individuals say they think pensions should come back, but I genuinely don’t believe that’s a better option for workers. What we do need is better education around financial literacy so people understand how to control their own retirement savings.

While a pension plan is a defined benefit plan, 401(k) and other retirement options are called a defined contribution plan. This means your employer agrees to contribute a set amount, typically in the form of a “match.” This means that if you give 2% of your salary to your retirement, your employer will “match” you and give 2% as well. At my last company, they would match 50% of what you put in, up to 2%. So If I put in 3%, they would put in 1.5%. However if I saved 5%, they would put in only 2%. So in order to get the most amount of money from my company, I put in 4% to make sure I was getting the full 2% “match”. This was taken out of each paycheck, and their contribution showed up on my paystub as well.

In the 1980’s, the government introduced a tax break in order to encourage savings. Any money you put into a 401(k) is considered pre-tax dollars, so that when you go to file your taxes for the year, the IRS won’t consider your contributions as part of your taxable income. This piece of IRS law is where the name 401(k) comes from. Now, there are a variety of retirement savings plans you can choose from with different tax impacts. I’ll cover more of the different retirement savings options in a later blog post.

At the end of the day, a 401(k) is an investing tool. I think it’s great for consumers to have their retirement money in their own hands, but understand that it’s a little scary. It requires you to manage and control your own financial future. So that’s why the next few articles will be on investing basics, beginning with What Is A Stock?

• Assets
• Finance Basics
• Investments