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The phrase “pension plan” often is used generically to refer to any sort of retirement plan offered by an employer. It could refer to a 401(k) plan, a money purchase plan, or many other plans. If you're self-employed, and don't have the benefit of an employer-sponsored plan, you can establish your own retirement savings plan through a SEP-IRA.
Traditionally, however, a pension plan is an employer-sponsored retirement plan, in which the employer contributes money to a retirement fund set up on behalf of the worker. When the worker retires, he receives fixed, periodic payments, on which he must pay taxes.
Traditional pension plans used to be more common than they are now, but they're still around, especially at larger companies. Seventy-seven percent of large companies in America still offer pension plans, although most mid-size or smaller companies have 401(k) savings plans.
Of the traditional type of pension plan, there are two kinds:
- Defined benefit plan
- Defined contribution plan
Both plans provide funding for your retirement. The difference is, with the defined benefit plan, the investment responsibility is on the employer, while the defined contribution plan puts the responsibility on the employee.
The defined benefit plan promises the employee a specified retirement benefit, based on a formula. The investment return risk is on the employer, who is responsible for funding and benefits.
If your company offers a defined benefit pension plan, it, in effect, promises you that if you work there for 30 years, retiring when you're 65, you'll get a monthly check for a certain amount of money (determined by the formula), for the rest of your life. The monthly pension payments are based on the number of years the retiree worked for the company and his salary during the years he worked. Different companies have different formulas for figuring out pension payments, but nearly all are based on years of service and salary.
Your employer is responsible for investing the money, and for being able to pay you the amount you've been promised when you retire.
Defined contribution plans generally are considered more advantageous to younger employees who have many years to invest. Defined benefit plans tend to be better for older workers who don't have a lot of years to let their investments work for them.
A defined contribution plan, on the other hand, promises an employee the value of the employee's account at retirement—whatever that value may be.
Although the employer is responsible for providing a satisfactory investment vehicle, the investment risk is on the employee.
Let's say that your employer contributes 10 percent of your salary each year to a defined contribution account in your name. If you make $45,000 this year, he'll throw $4,500 into your retirement account. Once he's contributed the money, however, it's your responsibility. You need to decide where you'll invest it, and you bear the investment risks. Whatever is in the account at retirement time is what you have.
Under a defined contribution plan, your employer has an individual account in your name. The employer's contributions are put into the account each year, with all income and capital gains taxes deferred until the money is withdrawn at retirement.
When you become eligible to receive benefits—usually at retirement—the benefit is based on the total amount in your account. The account balance includes the employer's contributions, whatever contributions you may have added to the account, and the earnings on the account for the years of deferral.
There are three principal types of defined contribution plans. Let's have a look at what each one entails.