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 earnings on the investments generate income to the worker upon retirement.
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.
Types of Pension Plans
There are two main 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 (the dollar amount is determined by a formula, usually based on earnings and years of service), 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. American employer-sponsored pension plans date from the 1870s, and at their height, in the 1980s, they covered nearly half of all private sector workers. About 90% of public employees, and roughly 10% of private employees, in the U.S are covered by a defined-benefit plan today.
In a defined-contribution plan, the employer makes specific plan contributions for the worker, usually matching to varying degrees the contributions made by the employees. The final benefit received by the employee depends on the plan's investment performance: The company’s liability to pay a specific benefit ends when the contributions are made. Because this is much less expensive than the traditional pension, when the company is on the hook for whatever the fund can't generate, a growing number of private companies are moving to this type of plan and ending defined-benefit plans. The best-known defined-contribution plan is the 401(k), and its equivalent for non-profits' workers, the 403(b).
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; vesting is based on the number of years of service and other factors.
Enrollment in a defined-benefit plan is usually automatic within one year of employment, although vesting can either be immediate or 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.
With defined-contribution plans, your individual contributions are 100% vested as soon as they reach your account. But if your employer matches those contributions or gives you company stock as part of your benefits package, it may set up a schedule under which a certain percentage is handed over to you each year until you are "fully vested." Just because retirement contributions are fully vested doesn’t mean you’re allowed to make withdrawals, however.
Are Pension Plans Taxable?
Most employer-sponsored pension plans are qualified, meaning they meet Internal Revenue Code and Employee Retirement Income Security Act of 1974 (ERISA) requirements. That gives them their tax-advantaged status. Employers get a tax break on the contributions they make to the plan for their employees. So do employees: Contributions they make to the plan come "off the top" of their paychecks – that is, are taken out of their gross income. That effectively reduces their taxable income, and, in turn, the amount they owe the IRS come April 15. Funds placed in a retirement account then grow at a tax-deferred rate, meaning no tax is due on them as long as they remain in the account. 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.
If you have no investment in the plan because you have not contributed anything or are considered to not have contributed anything, your employer did not withhold contributions from your salary or you have received all of your contributions (investments in the contract) tax free in previous years, your pension is fully taxable.
If you contributed money after tax was paid, your pension or annuity is only partially taxable. You don't owe tax on the part of the payment you made that represents the return of the after-tax amount you put into the plan. Partially taxable qualified pensions are taxed under the Simplified Method.
Can Companies Change Their Pension Plans?
What is a Pension Fund?
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. Run by a financial intermediary and managed by professional fund managers on behalf of a company and its employees, pension funds control relatively large amounts of capital and represent 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.
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.
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 generally results in a smaller monthly payout.