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.
BREAKING DOWN 'Pension Plan'
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).
In common parlance, "pension plan" often means the more traditional defined-benefit plan, with a set payout, funded and controlled entirely by the employer.
Some companies offer both types of plans. They even allow employees to roll over 401(k) balances into their defined-benefit plans.
There is another variation, the pay-as-you-go pension plan. Set up by the employer, these tend to be wholly funded by the employee, who can opt for salary deductions or lump sum contributions (which are generally not permitted on 401(k) plans). Otherwise, they similarly to 401(k) plans, except that they usually offer no company match.
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?
Some companies are keeping their traditional defined-benefit plans, but are freezing their benefits, meaning that after a certain point, workers will no longer accrue greater payments, no matter how long they work for the company or how large their salary grows.
When a pension plan provider decides to implement or modify the plan, the covered employees almost always receive a credit for any qualifying work performed prior to the change. The extent to which past work is covered varies from plan to plan. When applied in this way, the plan provider must cover this cost retroactively for each employee in a fair and equal way over the course of his or her remaining service years.
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.
Monthly Annuity or Lump Sum: Which Is Better?
With a defined-benefit plan, you usually have two choices when it comes to distribution: periodic (usually monthly) payments for the rest of your life or a lump sum distribution. Some plans allow you to do both, i.e., take out some of the money in a lump sum, and use the rest to generate periodic payments. In any case, there will likely be a deadline by which you have to decide, and your decision will be final.
There are several things to consider when choosing between a monthly annuity and a lump sum.
- Annuity. Monthly annuity payments are typically offered as a single life annuity for you only for the rest of your life – or as a joint and survivor annuity for you and your spouse. The latter pays a lesser amount each month (typically 10% less), but the payouts continue after your death, until the surviving spouse passes away.
Some people decide to take the single life annuity, opting to purchase a whole life or other type of life insurance policy to provide income for the surviving spouse. When the employee dies, the pension payout stops; however, the spouse then receives a large death benefit payout (tax-free) which can be invested and uses to replace the taxable pension payout that has ceased. This strategy, which goes by the fancy-sounding name pension maximization, may not be a bad idea if the cost of the insurance is less than the difference between the single life and joint and survivor payouts. In many cases, however, the cost far outweighs the benefit.
Can your pension fund ever run out of money? Theoretically, yes. But if your pension fund doesn’t have enough money to pay you what it owes you, the Pension Benefit Guaranty Corporation (PBGC) could pay a portion of your monthly annuity, up to a legally defined limit. For 2016, the annual maximum PBGC benefit for a 65-year-old retiree is $60,136. Of course, PBGC payments may not be as much as you would have received from your original pension plan.
Annuities usually pay out at a fixed rate. They may or may not include inflation protection. If not, the amount you get is set from retirement on. This can reduce the real value of your payments each year, depending on how the cost of living is going. And since it rarely is going down, many retirees prefer to take their money in a lump sum.
- Lump Sum. If you take a lump sum, you avoid the potential (if unlikely) problem of your pension plan going broke, or losing some or all of your pension if the company files for bankruptcy. Plus, you can invest the money, keeping it working for you – and possibly earning a better interest rate, too. If there is money left when you die, you can pass it along as part of your estate.
On the downside: No guaranteed lifetime income, as with an annuity. It’s up to you to make the money last. And, unless you roll the lump sum into an IRA or other tax-sheltered account, the whole amount will be immediately taxed and could push you into a higher tax bracket.
If your defined-benefit plan is with a public-sector employer, your lump sum distribution may only be equal to your contributions. With a private sector employer, the lump sum is usually the present value of the annuity (or, more precisely, the total of your expected lifetime annuity payments discounted to today's dollars). Of course, you can always use a lump sum distribution to purchase an immediate annuity on your own, which could provide a monthly income stream, including inflation protection. As an individual purchaser, however, your income stream will probably not be as large as it would with an annuity from your original defined-benefit pension fund.
Which Yields More Money?
With just a few assumptions, and a small amount of math, you can determine which choice yields the largest cash payout.
You know the present value of a lump-sum payment, of course. But in order to figure out which makes better financial sense, you need to estimate the present value of annuity payments. To figure out the discount or future expected interest rate for the annuity payments, think about how you might invest the lump sum payment and then use that interest rate to discount back the annuity payments. A reasonable approach to selecting the ‘discount rate’ would be to assume that the lump sum recipient invests the payout in a diversified investment portfolio of 60% equity investments and 40% bond investments. Using historical averages of 9% for stocks and 5% for bonds, the discount rate would be 7.40%.
Imagine that Sarah was offered $80,000 today or $10,000 per year for the next 10 years. On the surface, the choice appears clear: $80,000 versus $100,000 ($10,000 x 10 years): Take the annuity.
But the choice is impacted by the expected return (or discount rate) Sarah expects to receive on the $80,000 over the next 10 years. Using the discount rate of 7.40%, calculated above, the annuity payments are worth $68,955.33 when discounted back to the present, whereas the lump-sum payment today is $80,000. Since $80,000 is greater than $68,955.33, Sarah would take the lump-sum payment.
Other Deciding Factors
There are other basic factors that must almost always be taken into consideration in any pension maximization analysis. These variables include:
Your age. One who accepts a lump sum at age 50 is obviously taking more of a risk than one who receives a similar offer at age 67. Younger clients face a higher level of uncertainty than older ones, both financially and in other ways.
Your current health and projected longevity. If your family history shows a pattern of predecessors dying of natural causes in their late 60s or early 70s, then a lump-sum payment may be the way to go. Conversely, someone who is projected to live to age 90 will quite often come out ahead by taking the pension. Remember that most lump sum payouts are calculated based on charted life expectancies, so those who live past their projected age are, at least mathematically, likely to beat the lump sum payout. You might also consider whether health insurance benefits are tied to the pension payouts in any way.
Your current financial situation. If you are in dire straits financially, then the lump-sum payout may be necessary. Your tax bracket can also be an important consideration; if you are in one of the top marginal tax brackets, then the bill from Uncle Sam on a lump-sum payout can be murderous. And if you are burdened with a large amount of high-interest obligations, it may be wiser to simply take the lump sum to pay off all of your debts rather than continue to pay interest on all of those mortgages, car loans, credit cards, student loans and other consumer liabilities for years to come. A lump-sum payout may also be a good idea for those who intend to continue working at another company and can roll this amount into their new plan, or for those who have delayed their Social Security until a later age and can count on a higher level of guaranteed income from that.
The projected return on the client’s portfolio from a lump-sum investment. If you feel confident your portfolio will be able to generate investment returns that will approximate the total amount that could have been received from the pension, then the lump sum may be the way to go. Of course, you need to use a reasonable payout factor here, such as 3%, and don’t forget to take drawdown risk into account in your computations. Current market conditions and interest rates will also obviously play a role, and the portfolio that is used must fall within the parameters of your risk tolerance, time horizon and specific investment objectives.
Safety. If you have a low risk tolerance, prefer the discipline of annuitized income, or simply don't feel comfortable managing large sums of money, then the annuity payout is probably the better option because it’s a safer bet. In case of a company plan going bankrupt, along with the protection of the PBGC, state reinsurance funds often step in to indemnify all customers of an insolvent carrier up to perhaps two or three hundred thousand dollars.
The cost of life insurance. If you're in relatively good health, then the purchase of a competitive indexed universal life insurance policy can effectively offset the loss of future pension income and still leave a large sum to use for other things. This type of policy can also carry accelerated benefit riders that can help to cover the costs for critical, terminal or chronic illness or nursing home care. However, if you are medically uninsurable, then the pension may be the safer route.
Inflation protection. A pension payout option that provides a cost-of-living increase each year is worth far more than one that does not. The purchasing power from pensions without this feature will steadily diminish over time, so those who opt for this path need to be prepared to either lower their standard of living in the future or else supplement their income from other sources.
Estate planning considerations. If you want to leave a legacy for children or other heirs, then an annuity is out. The payments from these plans always cease at the death of either the retiree or the spouse, if a spousal benefit option was elected. If the pension payout is clearly the better option, then a portion of that income should be diverted into a life insurance policy, or provide the body of a trust.
Retirement and defined-contribution plans
With a defined-contribution plan, you have several options when it comes time to shut that office door.
- Leave In. You could just leave the plan intact and your money where it is. You may in fact find the firm encouraging you to do so. If so, your assets will continue to grow tax-deferred until you take them out. Under the IRS' required minimum distribution rules, you have to begin withdrawals once you reach age 70½. There may be exceptions, however, if you are still employed by the company in some capacity.
- Installment. If your plan allows it, you can create an income stream, using installment payments or an income annuity – sort of a paychecks-to-yourself arrangement throughout the rest of your retirement lifetime. If you annuitize, bear in mind that the expenses involved could be higher than with an IRA.
- Roll Over. You can roll over your 401(k) funds to a traditional IRA, where your assets will continue to grow tax-deferred. One advantage of doing this is that you will probably have many more investment choices. You can then convert some or all of the traditional IRA to a Roth IRA. You can also roll over your 401(k) directly into a Roth IRA. In both cases, although you will pay taxes on the amount you convert that year, all subsequent withdrawals from the Roth IRA will be tax-free. In addition, you are not required to make withdrawals from the Roth IRA at age 70½ or, in fact, at any other time during your life.
- Lump Sum. As with a defined-benefit plan, you can take your money in a lump sum. You can invest it on your own or pay bills, after paying taxes on the distribution. Keep in mind, a lump sum distribution could put you in a higher tax bracket, depending on the size of the distribution.