Pensions 101

Guide to Understanding Pensions

Pensions 101
March 9, 2016

Classically, a pension is a retirement plan where a company or governmental entity sets aside contributions for its employees' future retirement needs. These funds are invested to increase the available money pool used to meet those future obligations. But over the past 50 years, the definition of pension has expanded to include retirement plans where employees, as well as employers, participate in the funding of retirement benefits. Both classic and newer variants of pension funds are tax-exempt until the funds are withdrawn.

Types of Plans

Today, there are three basic types of pension plans:

  • Defined Benefit Plan – The classic pension, where the retiree’s future benefit amount is fixed regardless of the investment performance of the underlying pool of assets. Put simply, meeting this “defined benefit” becomes an obligation of the company or governmental entity, on a par with senior unsecured debt. Most public sector pensions are defined benefit (DB) plans, as are those of many large industrial companies.

    Employees do not make contributions to a DB pension plan, and have no input in how the money is invested. Benefits are typically calculated by averaging earnings over the later years of employment, while factoring in total years of service. Labor unions are deeply involved in the negotiation and modification of pension funds for their members. Because of the challenge in meeting these future benefits in a tumultuous investment climate, Defined Benefit plans are growing out of favor. Most new pension plans, therefore, are the Defined Contribution or Hybrid Plans described below.

  • Defined Contribution Plan – As the name suggests, it is the “contribution” made into this type of plan (on behalf of the employee) that is defined, not the future benefit. Therefore, future benefits are dependent on investment results of the plan.. Defined contribution plans include 401(k) plans, ESOPs (Employee Stock Option Plans), profit sharing plans, and similar vehicles. Depending on the plan, contributions are made by the employee, employer, or both. Most new private sector plans today are defined contribution or hybrid plans. 401(k) plans have proven to be extremely popular since their introduction in 1983, due to the appeal of employer matching funds and the ability of plan participants to select their own investments.
  • Hybrid Plans – Newer variations of pension plans include SEPs (Simplified Employee Pension Plans), where employers make contributions to IRA's that are owned by employees, and Money Purchase Pension plans, where contributions are made as a fixed percentage of the employee's compensation.

    Cash-Balance Pension plans are an interesting hybrid; they are defined benefit plans that use terms of an account balance. Employers make annual contributions in an account for each employee as a pay credit (fixed percentage of compensation) plus an interest credit (variable, based on some index value). The advantage of a cash-balance pension is that it's portable, unlike other defined benefit plans.

Vesting and Withdrawals

Pension plans require employees to be vested in the company, typically three to five years. The vesting schedule may be a cliff (0% until a certain employment period is reached, then 100%) or a graded scale (for example, 20% vested after 3 years and 20% per additional year until 100% vested).

If you leave before retirement, your amount of pension depends on a combination of the vesting schedule and length of employment. You'll have to apply for your benefits when you reach retirement age.

Most pensions are set with a retirement age of 65 years, although some allow withdrawals before age 65, with reduced funds (and potential tax concerns). Withdrawals from a Defined Contribution plan, such as a 401(k), are relatively simple and are made at the discretion of the employee, once retirement age is reached.

Payouts from a Defined Benefit plan may be in two forms:

  • Annuity - Provides a set monthly income until your benefits are exhausted or you pass away. If your annuity is a single life annuity, the benefits end when you die with the pension fund retaining any unused benefits. With a joint-and-survivor annuity, your spouse will continue to receive some portion of your benefits until his or her death.

  • Lump Sum - Benefits are paid in a single payment. While an annuity provides regular income, the lump sum allows you to keep control of the money and invest it yourself, as well as allowing you to transfer it to heirs. However, you will need to consider the tax effects.

  • While most pension plans are secure and well managed, they are not completely bulletproof. Defined Benefit plans are of special concern because if the company or governmental entity goes bankrupt, future benefit payouts may be reduced or lost entirely (for a painful history lesson, Google “Enron pension funds”).

    Private company Defined Benefit plans are at least partially protected by the Pension Benefit Guarantee Corporation (PBGC), which was created by ERISA (the Employee Retirement Income Security Act). Public pension plans are usually guaranteed by state law (and perhaps state constitution); however, with huge funding shortfalls, these are increasingly under fire.

    It's wise to keep close tabs on your pension program, and supplement it however you can. IRA’s and Health Savings Accounts are two popular vehicles for doing so. If you're in a public sector pension plan, or have worked in both public and private positions, check with the SSA (Social Security Administration) to verify your status, as your Social Security benefits may be affected. Finally, if you are considering changing jobs, or have multiple job offers, ask about the pension plans at stake and compare them; the differences between them could be enough to seal the deal.

    Let the free MoneyTips Retirement Planner help you calculate when you can retire without jeopardizing your lifestyle.

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