What is a Pension Plan?
A pension plan is a commitment by an employer to make regular contributions to a dedicated fund intended to provide payments to eligible employees upon retirement.
In the United States, traditional pension plans known as defined-benefit plans are less common and are being replaced by less costly defined-contribution plans like the 401(k).
Key Takeaways
- Pension plans require employer contributions to a retirement fund.
- A defined-benefit plan guarantees a specific retirement payment.
- A defined-contribution plan, like a 401(k), relies primarily on employee contributions.
- Defined-benefit plans are funded mainly by the employer.
- Defined-contribution plans transfer the savings and investment responsibilities to employees.
Understanding Pension Plans
Types
Two main types of pension plans exist: defined-benefit plans and defined-contribution plans.Each has unique characteristics and benefits for employees and employers alike.
Defined-Benefit Pension Plan
In a defined-benefit plan, the employer ensures that the employee receives a specific monthly payment upon retirement, determined by a formula considering earnings and years of service.
Historical Note: Employer-sponsored defined-benefit pension plans date back to the 1870s.
Defined-Contribution Pension Plan
For defined-contribution plans, employees make contributions that may be matched by the employer. The retirement benefit depends on the investment performance.
Example: The 401(k) is a popular defined-contribution plan used by many companies as an alternative to traditional pensions.
Variations of Pension Plans
Companies sometimes offer both defined-benefit and defined-contribution plans. Some even allow 401(k) rollovers into pension plans.
Another variation is the pay-as-you-go pension plan, which is primarily funded by the employee through salary deductions or lump-sum contributions.
Pension Plans & ERISA
The Employee Retirement Income Security Act of 1974 (ERISA) protects retirement assets by imposing guidelines on retirement plan fiduciaries.
Plan sponsors must provide detailed information about investment options and company-matched contributions. Employees need to understand vesting—how long until they earn the right to pension assets fully.
Vesting
Defined-benefit plan enrollment is usually automatic. However, full vesting can take up to seven years. Defined-contribution plans typically offer immediate vesting of employee contributions.
Taxation
Employer-sponsored pension plans generally meet Internal Revenue Code 401(a), granting tax-advantaged status. Employee contributions reduce taxable income as they come from gross income.
Withdrawals from pension plans are taxable upon retirement. State taxes may also apply.
Modified Pension Plans
Some companies freeze all future benefits but retain traditional defined-benefit plans. When applied, past work before changes is usually credited, ensuring employees receive fair contributions towards future benefits.
Pension Funds
Defined-benefit plans with pooled contributions are referred to as pension funds managed by professional fund managers. These funds are usually tax-deferred or tax-exempt.
Pension Plans vs. 401(k)
Pension Plans:
- Risk on the employer
- Guaranteed lifetime income
- Employer controls investment strategy
- Longer vesting period
- Cannot be easily rolled over
401(k) Plans:
- Risk on the employee
- No guarantee of benefits
- Employee controls investment strategy
- Shorter vesting period
- Easily portable
Monthly Annuity or Lump-Sum? Consider Your Choices
A defined-benefit plan usually offers periodic payments or lump-sum distributions. Decisions should incorporate factors like inflation protection, current health, expected longevity, and estate planning.
Example: Deciding between taking $80,000 in a lump-sum or $10,000 per year for ten years involves understanding present value calculations.
Which Yields More: Lump-Sum or Annuity?
Use expected return assumptions to calculate the present value of annuity payments vs. a lump-sum. Financial calculators or advisory services can help make an informed decision.
How Does a Pension Work?
Employers guarantee specific retirement payments if an employee works for the company long enough. Pension benefits may be claimed upon retirement, whether or not the retiree is still with the company.
Getting Vested Under a Pension Plan
Vesting varies from immediate to several years. Employee contributions are always vested, while employer contributions vest after prolonged employment.
Is a Pension Better Than a 401(k)?
Pensions offer guaranteed benefits, while 401(k)s offer employee control and upside potential. Pensions may be safer for long-term security, but 401(k)s cater to employees who can oversee their investments directly.
Who Gets a Pension?
Eligibility depends on working for a company offering a pension plan, frequently requiring meeting vesting requirements.
Bottom Line
Pension plans provide valuable retirement benefits, primarily funded by employers. These benefits ensure financial security throughout retirement—a significant consideration when planning for your future. Investing in your retirement today secures your financial freedom tomorrow.
Related Terms: 401k, Defined-Benefit Plans, Defined-Contribution Plans, ERISA, Vesting, Tax Deferred.
References
- Internal Revenue Service. “Defined Benefit Plan”.
- U.S. Department of Labor. “Types of Retirement Plans”.
- U.S. Department of Labor. “What You Should Know About Your Retirement Plan”, Page 6.
- Social Security Administration. “The Disappearing Defined Benefit Pension and Its Potential Impact on the Retirement Incomes of Baby Boomers”.
- Pension Benefit Guaranty Corporation. “History of PBGC”.
- U.S. Department of Labor. “What You Should Know About Your Retirement Plan”, Page 4.
- Internal Revenue Service. “IRC 403(b) Tax-Sheltered Annuity Plans”.
- Internal Revenue Service. “Rollover Chart”.
- U.S. Department of Labor. “ERISA”.
- U.S. Department of Labor. “Plan Information”.
- U.S. Department of Labor. “FAQs about Retirement Plans and ERISA”, Page 2.
- U.S. Department of Labor. “FAQs about Retirement Plans and ERISA”, Page 4.
- U.S. Department of Labor. “FAQs about Retirement Plans and ERISA”, Page 1.
- Internal Revenue Service. “A Guide to Common Qualified Plan Requirements”.
- Internal Revenue Service. “Government Retirement Plans Toolkit”.
- Office of New York State Comptroller. “Taxes and Your Pension”.
- Internal Revenue Service. “Topic No. 410, Pensions and Annuities”.
- Internal Revenue Service. “Topic No. 411, Pensions – The General Rule and the Simplified Method”.
- Internal Revenue Service. “Publication 575, Pension and Annuity Income”.
- Pension Benefit Guaranty Corporation. “Annuity or Lump Sum”.
- U.S. Bureau of Labor Statistics. “You’re Getting a Pension: What Are Your Payment Options?”
- PBGC. “Maximum Monthly Guarantee Tables”.
