📚 U.8. What is a pension?
What Is a Pension?
What Is a Pension Plan?
A pension plan is a type of retirement plan where employers promise to pay a defined benefit to employees for life after they retire. It’s different from a defined contribution plan, where employees put their own money in an employer-sponsored investment program. Pensions grew in popularity during World War II and became mainstays in benefit packages for government and unionized workers. While they remain common in the public sector, they’ve largely been supplanted by defined contribution plans in the private sector. In an ideal world, an employer who offers a pension plan sets aside money for each employee and that money grows over time. The proceeds then cover the income the company promised to pay the employee in retirement. Often, the employee has the choice of taking either a lump sum on retirement (or when leaving the company) or regular payments for life through an annuity. Depending on the plan, those pension benefits may be inheritable by a surviving spouse or children.
Your pension income is usually paid out as a percentage of your salary during your working years. That percentage depends on the terms set by your employer and your time with the employer. A worker with decades of company or government tenure may get 85% of their salary in retirement. One with less time under their belt, or at a less generous employer, may only receive 50%.
Employees with pensions don’t participate in the management of those funds. This is considered a plus since most people aren’t financial experts. But on the flip side, the lack of control means employees are powerless to ensure that their pension funds have adequate financing. They also must trust their company to stay in business during their lifetime. Though if the company goes bankrupt, the pension will terminate and payments from the Pension Benefit Guaranty Corporation will kick in to cover all or most of it.
If you leave your employer before your pension benefits vest, you forfeit the money your company put aside for your retirement. Vesting schedules come in two forms: cliff and graded. With cliff vesting, you have no claim to any company contributions until a certain period of time has passed. With graded vesting, a certain percentage of your benefits vest each year, until you reach 100% vesting.
The Defined-Benefit Plan
In a defined-benefit plan, the employer guarantees that the employee will receive a specific monthly payment after retiring and for life, regardless of the performance of the underlying investment pool. The employer is thus liable for pension payments to the retiree in a dollar amount typically determined by a formula based on earnings and years of service.
The Defined-Contribution Plan
In a defined contribution plan, the employee makes contributions, which may be matched by the employer. The final benefit to the employee depends on the investment performance of the plan. The company’s liability ends when the total contributions are expended.
Pension Plan vs. Pension Funds
When a defined-benefit plan is made up of pooled contributions from employers, unions, or other organizations, it is commonly referred to as a pension fund.
Managed by professional fund managers on behalf of a company and its employees, pension funds can control vast amounts of capital and are among the largest institutional investors in many nations. Their actions can dominate the stock markets in which they are invested.
Pension funds are typically exempt from capital gains tax. Earnings on their investment portfolios are tax-deferred or tax-exempt.
A pension fund provides a fixed, preset benefit for employees upon retirement, helping workers plan their future spending. The employer makes the most contributions and cannot retroactively decrease pension fund benefits.
Voluntary employee contributions may be allowed as well. Since benefits do not depend on asset returns, benefits remain stable in a changing economic climate. Businesses can contribute more money to a pension fund and deduct more from their taxes than with a defined contribution plan.
A pension fund helps subsidize early retirement for promoting specific business strategies. However, a pension plan is more complex and costly to establish and maintain than other retirement plans. Employees have no control over the investment decisions. In addition, an excise tax applies if the minimum contribution requirement is not satisfied or if excess contributions are made to the plan.
An employee’s payout depends on the final salary and length of employment with the company. No loans or early withdrawals are available from a pension fund. Taking early retirement generally results in a smaller monthly payout.
