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What is a 'Pension Plan'

A pension plan is a retirement plan that requires an employer to make contributions into a pool of funds set aside for a worker's future benefit. The pool of funds is invested on the employee's behalf, and the tax exempt earnings on the investments generate an income benefit to the worker upon retirement.

BREAKING DOWN 'Pension Plan'

In addition to an employer's required contributions, some pension plans have a voluntary investment component. A pension plan may allow a worker to contribute part of his current income from wages into an investment plan to help fund retirement. The employer may also match a portion of the worker’s annual contributions, up to a specific percentage or dollar amount. There are two main types of pension plans: defined-benefit plans and defined-contribution plans.

The Differences Between Types of Pension Plans

In a defined-benefit plan, the employer guarantees that the employee receives a definite amount of benefit upon retirement, regardless of the performance of the underlying investment pool. The employer is liable for a specific flow of pension payments to the retiree, and if the assets in the pension plan are not sufficient to pay the benefits, the company is liable for the remainder of the payment.

On the other hand, a defined-contribution plan means that the employer makes specific plan contributions for the worker, but the final amount of benefit received by the employee depends on investment performance. Under a defined-contribution plan, the company’s liability to pay a specific benefit ends when the contributions are made, and a growing number of firms are moving to this type of plan and ending defined-benefit plans.

Both types of plans allow the worker to defer tax on the retirement plan’s earnings until withdrawals begin, and this tax treatment allows the employee to reinvest dividend income, interest income and capital gains, which generates a much higher rate of return before retirement.

Factoring in ERISA

The Employee Retirement Income Security Act of 1974 (ERISA) is a Federal law designed to protect the retirement assets of investors, and the law specifically provides guidelines that retirement plan fiduciaries must follow to protect the assets of private sector employees.

Companies that provide retirement plans are referred to as plan sponsors (fiduciaries), and ERISA requires each company to provide a specific level of plan information to employees who are eligible. Plan sponsors provide details on investment options and the dollar amount of worker contributions that are matched by the company, if applicable. Employees also need to understand vesting, which refers to the dollar amount of the pension assets that are owned by the worker, and vesting is based on the number of years of service and other factors.

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