Q. I’m thinking about taking a state job so I can have a pension when I retire. I’m 40. Am I better off staying with my job that has a 401(k) with a 2 percent employer match? I can only afford to save 10 percent of my $55,000 salary. Or would I have to pay into the pension?
— Planning ahead
A. At age 40, you’re wise to think about retirement because time is your ally when making long-term plans.
Your question about the relative advantage of a 401(k) plan versus a pension is like comparing apples and oranges.
Let’s first take a look at some of the major differences.
Your 401(k) plan is a type of defined contribution profit-sharing plan into which you and your employer are making contributions, said Gene McGovern, of McGovern Financial Advisors in Westfield.
In a traditional 401(k) plan, employees have individual savings accounts and can choose among various investments, such as stock, bond and money market mutual funds, he said. Employees bear all of the investment risk.
“At retirement, there’s no guarantee of a monthly payment or a specific balance in the account,” McGovern said. “Traditional 401(k) plans promise only to defer taxation on contributions and earnings while often providing for some type of employer matching contribution.”
Defined benefit pension plans, in contrast, generally pay a fixed monthly benefit at retirement for life.
McGovern said the benefit is usually computed based on a formula that takes into account the number of years of service or plan participation and your final average salary over the last few years of employment. Plan participants do not have separate investment accounts, so the employer, rather than the employee, bears all of the investment risk.
New Jersey offers a number of different retirement plans for various types of state, county and municipal employees, funded by both the state and local governments and administered by the Department of the Treasury’s Division of Pensions and Benefits.
Some of these, such as the Public Employees’ Retirement System (PERS) and the Teachers’ Pension and Annuity Fund (TPAF), are defined benefit pension plans, McGovern said.
“Defined benefit plans offer monthly income for life, which addresses one of the biggest risks facing retirees — longevity risk, or the risk of outliving your money,” he said. “On the other hand, cost of living adjustments for pension payments were suspended in 2011 as part of the pension reform package enacted under then-Gov. Christie, so New Jersey pension payments currently don’t address one of the other major risks facing retirees: inflation.”
As a PERS or TPAF participant, you would have to pay into plan.
Under the pension reforms, employee contributions to those plans have been rising over the last seven years and are scheduled to reach 7.5 percent of base salary as of July 1, 2018, McGovern said. The normal retirement age for these plans has also been increasing, and is currently 65 for those who enrolled on or after June 28, 2011, he said.
To your specific question of whether you would be better off remaining in your current job with a 401(k) plan or working for the state and earning pension benefits, the answer depends not only on your current individual circumstances but also on your long-range goals, needs, plans and assumptions.
Your choices aren’t mutually exclusive, either. For example, you could potentially contribute to an IRA or Roth IRA account while participating in a pension plan, McGovern said.
To give you a more concrete sense of the alternatives, McGovern offered two hypothetical employment paths for you — Case 1 and Case 2 — starting with your existing salary and contribution rates.
In Case 1, you remain with a private sector employer, saving 12 percent of your current $55,000 salary — 10 percent your contributions and 2 percent employer match — over 25 years. Let’s assume that you can earn an average return of 7 percent over that period, and receive an average 2 percent salary increase each year.
“After 25 years, your 401(k) plan balance would be in the neighborhood of $500,000, plus whatever your existing account balance has grown to,” he said. “From that, you could safely withdraw perhaps 4 percent annually, or about $20,000 per year, increased each subsequent year for inflation.”
In Case 2, assume that you find a state job that also pays $55,000, that you work 25 years until age 65 (the plan retirement age), and receive the same raises each year averaging 2 percent.
“Under the current formula used to compute your retirement allowance, your lifetime annual benefit would be a fixed amount of roughly $35,000, depending on how you elect to receive the benefits,” McGovern said.
Of course, these numbers make several simplifying assumptions and ignore the effects of federal and state income taxes, he said. Nevertheless, they illustrate that a defined benefit pension plan can be more advantageous than a 401(k) plan in certain circumstances.
“On the other hand, these numbers also ignore the current multi-billion-dollar funding shortfall in the New Jersey pension system, which could lead to further changes in plan rules and benefits in the future,” he said.
Ultimately, the retirement plan tail shouldn’t wag the career dog.
Email your questions to moc.p1540227985leHye1540227985noMJN1540227985@ksA1540227985.