Saving For Retirement: 5 Things Every Young Professional Must Know.
You have been working for a couple of years now, and you might be already thinking about your next financial move.
You may be saving money to buy a house, plan for your wedding, or to launch a business on the side.
But as a young professional, you might very well be part of the 50% who are not actively saving for retirement.
If that is the case, here are some important facts you should know to get started:
1. A pension plan is treated either as a defined contribution or a defined benefit plan
Pension funds are like huge piggy banks that a group of people contributes to.
The owner of the piggy bank (e.g. an investment firm, your employer, or the government) allows people to deposit a certain amount every month until they retire.
The pension fund can be based on a defined contribution (DC) plan, which means each person contributes a defined amount to his or her own section of the piggy bank and receives the proceeds from the invested amount upon retirement.
Alternatively, the fund can be based on a defined benefit (DB) plan in which the owner of the piggy bank promises you a pre-determined amount upon retirement.
In none of these scenarios are your contributions kept under a mattress; instead, they are invested on the financial market. Therefore there is a risk of loss if the investment does not perform well.
The difference is that in a DC plan, you bear that risk alone, whereas in a DB plan the investment risk is shared or fully assumed by the sponsor.
2. All pension plans can be narrowed down to three basic categories
There are essentially three schemes under which you could receive retirement benefits (DB or DC plan):
1. Public pension plans
Pension plans provided by the government represent the first layer of social security.
They are typically financed through taxes you pay and are aimed to benefit most people.
These plans may be contributory, with contributions typically paid from your salary (e.g. Canada Pension Plan) or non-contributory. Benefit options and requirements vary from one country to another.
2. Corporate pension plans
Corporate pension plans are provided by private companies for their employees.
It may serve as a primary or complementary source of retirement income in addition to public pension benefits.
In several instances, the contributions you pay will be matched by your employer, thus putting more money in your retirement account.
DB pension plans tend to be less risky for employees, but DC plans like the 401(k) in the United States have become much more popular because companies can avoid the risk of deficit.
3. Individual retirement plans
An individual retirement plan is an account you can open yourself with a financial institution.
It acts as an investment or savings vehicle that generally provides tax advantages. Retirement benefits can be distributed either as an annuity or a lump sum.
Typical examples are Individual Retirement Accounts (IRAs) in the U.S. and Registered Retirement Savings Plan (RRSP) in Canada.
In such plans, you are responsible for choosing the types of investments towards which the funds will be allocated (e.g. mutual funds, stocks, bonds, etc).
3. Saving for retirement is not risk-free: Avoid having your money in the wrong place at the wrong time.
When financial markets perform poorly or interest rates are low (as they have been lately), pension funds accumulate slowly and may even depreciate.
As a matter of fact, since the 2008 financial crisis, many public and private pension investment funds have been struggling with huge losses.
For DC plan members who were about to retire but lost most of their savings, this meant working for an extra 10 to 15 years in the hope of recovering from the loss and maintaining a decent standard of living upon retirement.
For DB plan members, who were promised a pre-determined benefit regardless of how the fund performed, this meant transferring the fund deficit to future generations of retirees, hoping the markets will pick back up.
So in general, there are two scenarios you want to avoid upon retirement: 1) watching your money shrink under a DC plan because of another financial crisis and 2) watching your money shrink under a DB plan because of inadequate funding.
4. You won’t be able to rely on the government when you retire
Several Public (DB) pension plans in the West have become very uncertain because they are unfunded.
This means benefits are paid directly out of current contributions, on a first-come-first-served basis, and no asset is set aside to ensure present contributions will be enough to meet upcoming benefits.
This is called a PAYGO system. So because there is no cushion, deficits have been dragging over decades due to a poor economy and an aging population.
Governments seldom have money to absorb the deficit, and they can’t count anymore on future contributions as nativity drops while pensioners are living longer.
As a result, there will be fewer contributors to fund young people’s retirement.
You may therefore have to pay higher contributions (i.e. taxes) than your parents did for the same amount of benefits; you may start receiving your benefits at an older age; or you may simply receive fewer benefits upon your retirement than previous generations did.
Hence the importance of contributing early to corporate and individual retirement plans.
5. You don’t have to wait 30 years to benefit from your retirement account
Saving for your retirement is not very different from managing the regular savings and investment accounts you may already have. However, as a young professional, you can benefit from short-term advantages like:
1. Employer contributions
In many corporate pension plans, employers match your contributions, thus granting you ‘free money’ for every dollar you put in your retirement account.
2. Special tax provisions
In a lot of cases, the interest earned in your individual retirement account is not taxed.
Plus, your contributions to such accounts may be tax-deductible, thus reducing the income tax you will end up paying.
For example, Canadians were able to deduct up to $23,000 from their 2012 taxable income, and could even roll over unused tax deductions to future years.
3. Transfer between Spouses
Partners can reduce their tax burden by pooling their retirement contributions. In some states, this applies to same-sex couples as well.
4. Free credit
Although early withdrawals from retirement accounts are generally taxed, you may be allowed to ‘borrow’ your money tax-free under special circumstances like buying a house or financing your education.
For example, in Canada, you can use your RRSP as a down payment on a mortgage to get a better deal from your bank.
That’s all on Saving For Retirement: 5 Things Every Young Professional Must Know.
This article was written by Meinna Gwet. Her specialty is in enterprise risk management for banks and insurance companies.