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What is a 'Pension Fund'

A pension fund is a common asset pool run by a financial intermediary on behalf of a company and its employees, to generate stable growth over the long term and provide pensions for the employees when they retire. Pension funds control relatively large amounts of capital and represent the largest institutional investors in many nations.

BREAKING DOWN 'Pension Fund'

A pension fund is a defined benefit plan made up of pooled contributions from employers, unions or other organizations providing the retirement benefits for employees or members. Pension funds make up most countries’ biggest investment blocks and dominate the stock markets in which they are invested. Pension funds managed by professional fund managers make up the institutional investor category with insurance companies and investment trusts. Pension funds are typically exempt from capital gains tax. Earnings on their investment portfolios are tax deferred or tax exempt.

Advantages and Disadvantages of a Pension Fund

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 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.

Enrollment in a pension fund is automatic within one year of employment, although vesting can be immediate and spread out over seven years. Limited benefits are provided, and leaving a company before retirement may result in losing some or all of an employee’s pension benefits.

An employee’s payout depends on his salary and length of employment with the company. No loans or early withdrawals are available from a pension fund. In-service distributions are not allowed to a participant before age 62. Taking early retirement results in a smaller monthly payout.

Depending on an individual’s needs, payout choices include a lump sum or monthly payments. Taking a lump sum gives an employee more control over investing his money and protects him from losing his pension if the company becomes insolvent. Choosing monthly payments over a lump sum distribution may result in losing some or all of one’s pension if the company files for bankruptcy. The chosen payment distribution may not be changed, posing a challenge if one needs additional income in the future. All earnings are taxable at the federal level and potentially at the state level upon withdrawal.

Because an employee’s pension will not cover all expenses during retirement, workers are encouraged to participate in other company-sponsored retirement plans or invest in retirement accounts outside the company.

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