Fewer companies are providing their employees traditional pension plans, requiring employees to rely more heavily
on 401k and other private retirement plans. The exceptions are government jobs and in unionized firms where employees
are continuing to benefit from programs established or negotiated when civil service jobs paid lower salaries or when there
was less international competition for America’s goods and services. Older employees may also benefit from pension
plans received as a result of continuous service at firms that once offered pension plans to all employees as a normal employment
A pension is an arrangement to provide a person with an income during retirement when they are no longer earning a steady
income from employment. They are retirement plans that are mostly fully paid by the employer, providing the employee
with defined benefits in retirement. But often they require both the employer and employee to contribute money to a
fund during the employment period in order to receive benefits.
Pensions are a tax-deferred savings vehicle that allows for the tax-free accumulation of a fund for later use for retirement
income. Pension plans are therefore a form of "deferred compensation". Rules governing the establishment,
funding and payout provisions for pensions are usually governed by pre-determined legal and/or contractual terms. Retirement
plans may be set up by employers, insurance companies, the government or other institutions such as employer associations
or trade unions.
If your pension is from work where you paid Social Security taxes, it will not affect the amount of your Social Security benefit.
However, if any part of your pension is from work where you did not pay Social Security taxes, it could affect the amount
of your Social Security benefit.
Retirement plans may be classified as defined benefit or defined contribution according to how the benefits
- Defined benefit plan – Guarantees a certain payout at retirement, according
to a fixed formula that incorporates the employee's salary, years of employment, age at retirement, and other factors.
contribution plan – Provides a payout at retirement that is dependent upon the amount of money contributed
and the performance of the investment vehicles utilized.
Some types of retirement plans, such as cash balance plans, combine features of both defined benefit and defined
contribution plans. They are often referred to as hybrid plans. Such plan designs have become
increasingly popular in the US since the 1990s. Examples include Cash Balance and Pension Equity plans.
Defined Benefit Plans
Defined benefit plans are the more traditional pension plans. Their benefits are based either on the employee’s
final salary at retirement or the employee’s Final Average Pay (FAP). While the Final Salary Plan
is popular among unionized workers, FAP remains the most common type of defined benefit plan offered in the United States.
In FAP plans, the average salary over the final (3-5) years of an employee's career determines the benefit amount.
If the pension plan allows for early retirement, payments are often reduced to recognize that the retirees will receive the
payouts for longer periods of time. In the United States, under the Employee Retirement Income Security Act of 1974,
any reduction factor less than or equal to the actuarial early retirement reduction factor is acceptable.
Many defined benefit plans include early retirement provisions to encourage employees to retire early, before the attainment
of normal retirement age (usually age 65). Companies would rather hire younger employees at lower wages. Some
of those provisions come in the form of additional temporary or supplemental benefits, which are payable to a certain age,
usually before attaining normal retirement age.
And there is the ceiling on pensionable compensation for “qualified”
pension plans under the provisions of the Internal Revenue Code, Section 401(a)(17). This limit is $250,000 in 2012.
Defined benefit plans may be either funded or unfunded. In an unfunded defined benefit pension,
no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid.
Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly
from current workers' contributions and taxes. This method of financing is known as Pay-as-you-go (PAYGO).
In a funded plan, contributions from the employer, and sometimes also from plan members, are invested in a fund towards
meeting the benefits. The future returns on the investments, and the future benefits to be paid, are not known in advance,
so there is no guarantee that a given level of contributions will be enough to meet the benefits. Typically, the contributions
to be paid are regularly reviewed in a valuation of the plan's assets and liabilities, carried out by an actuary to ensure
that the pension fund will meet future payment obligations.
Pension Benefit Guaranty Corporation
In the United States, non-church-based private employers must pay an insurance-type premium to the Pension Benefit Guaranty
Corporation (PBGC), a government agency whose role is to encourage the continuation and maintenance of voluntary private pension
plans and provide timely and uninterrupted payment of pension benefits.
PBGC is a federal agency created by the Employee Retirement Income Security Act of 1974 (ERISA) to protect pension benefits
in private defined benefit plans – the kind that typically pay a set monthly amount at retirement. If your plan
terminated without sufficient money to pay all benefits, PBGC’s insurance program will pay you the benefit provided
by your pension plan up to the limits set by law. Currently, the limit is about $56,000 for a 65-year-old. There
are other types of limits, too, such as for early retirement benefits.
Defined Pension Plan Analysis
There are several characteristics of traditional defined benefit plans worth mentioning:
The present value of benefits grows slowly early in an employee's career and accelerates significantly in mid-career –
in other words it costs more to fund pensions for older employees than for younger ones.
Defined benefit pensions tend to be less portable than defined contribution plans, even if the plan allows a lump sum cash
benefit at termination.
Open-Ended Risk: Defined benefit plans are an open-ended
risk to employers. Their cost is not easily calculated and requires an actuary or actuarial software. Even with
the best tools, the cost will always be an estimate based on economic and financial assumptions. This is the reason
many employers switched from defined benefit to defined contribution plans over recent years.
These factors make defined benefit plans better suited to large employers with less mobile workforces, such as the public
sector (which has open-ended support from taxpayers).
Defined benefit plans are typically more valuable than defined
contribution plans in most circumstances and for most employees (mainly because the employer tends to pay higher contributions
than under defined contribution plans).