There are three ways retirement is financed for most working Americans.
1. Social Security. If you work, and contribute to Social Security for a minimum number of quarters, you are eligible for retirement. You have no control over it from the stand point of growing it as an investment, since the only way it gains is by you paying social security taxes ,, which means either you have salary earnings or business income. It also caps off at an average of $ 3,000 a month.
2. Employer paid retirement. Employers have either Defined Benefit Plans or Defined Contribution Plans. If you are not part of a union, chances are you are under a DCP. Only Unions have been able to pad their retirement plans with very high vesting rights (explained below) – one reason why many private industries do not have unions and where unions exist, in government, most of these plans are bankrupt.
Under DCP, you “contribute” by staying employed with the same employer. Each year, based on your salary, bonus and years of service, you are “vested” ie entitled to a percentage of your last computed salary – sometimes average of precedent five years sometimes less. Again, you have very little control over this as an investment since it is usually invested very conservatively and managed by the employer under its own set of rules.
3. Self-funded retirement plans: You are allowed to contribute to an Individual Retirement Plan, or participate in employer-provided 401K plan (403 for certain professions like teachers). Most of the time, your employer will match fund your contribution upto pre-designated limits.
Here are some tips for making sure your retirement plan, whether as an investment or a nest egg, grows prudently.
1. For self managed plans, make sure you diversify. Major areas of diversification are: Equity, Fixed Income, Real Estate and Commodities. Either use the investment tools or talk to a financial advisor. Even though your 401k is managed by your employer, you can choose from a menu of investment choices given by your employer.
2. For non-managed plans, such as DCP, make sure your earnings, including overtime bonus etc. ie all “eligible” earnings are accurately counted and tracked by your employer.
3. If you have a high rate loan outstanding, sometimes it may make sense to borrow from your retirement account, since you will be paying interest to yourself and it is generally lower than market interest rate.
4. Make sure you contribute maximum allowable to a managed retirement account like IRA or 401K. You are saving at a tax-deferred rate and it means your savings will rise much more quickly since you pay no tax till you withdraw – loans are not considered withdrawals.
5. If leaving the employer, make sure they give you proper credit. Particularly for young people, retirement is far away and they may not care as much about DCP's or DBP's. Make sure you do not get short-changed because it is much harder to go back several years and try to get the information, much less to correct it. This will have a direct impact on your pension.