What Is a Corporate Pension Plan?
A corporate pension plan is a benefit that provides income in retirement based on the employee's length of service to the company and salary history.
Pension plans for American workers have become rare outside of government employment. According to the Bureau of Labor Statistics, in 2019, the percentage of state and local government workers who participated in a workplace retirement plan was approximately 83%. Of those workers, about 77% had an actual pension plan, and an estimated 17% had another type of retirement savings plan.
Currently, the best access to pension plans in the private sector is via very large companies; however, pensions in corporate America are disappearing rapidly. In 2019, only 13% of private-sector employees had pension plans; they are being replaced by the popular 401(k) and other defined-contribution plans.
- Pension plans are becoming increasingly rare in the private sector, although most civil service employees get them.
- In a defined-benefit pension plan, a company commits to a specific payment amount for life to each eligible employee, depending on his or her length of service and salary at retirement.
- A defined-contribution pension plan requires the company or employee, or both, to contribute regular sums towards a retirement income, and the payments depend on investment returns.
Understanding Corporate Pension Plans
Typically, pension plans have a vesting period that requires employees to work for the company for a minimum number of years before becoming eligible. The individual benefit is based on the employee's length of service and salary history with the company. In the past, employers were wholly responsible for contributing to the plan, but this is becoming increasingly rare.
Two of the most common types of pension plans are the defined-benefit plan and the defined-contribution plan. The defined-benefit plan represents a traditional approach to pensions, and the defined-contribution plan is the model that has been widely adopted in recent years.
The Defined-Benefit Pension Plan
In a defined-benefit plan, the company commits to a specific payment amount for the lifetime of the employee. The benefit is calculated in advance of the employee's retirement, using a formula based on the employee's age, length of service, and salary at retirement. In the U.S., the maximum retirement benefit permitted under a defined-benefit plan in 2021 is $230,000, unchanged from 2020; the maximum benefit is subject to cost-of-living adjustments (COLA) in future years.
Defined-benefit plans may be funded exclusively by the employer or jointly by the employer and the employee. The pension fund is financed from a pool of funds from which periodic payments to retired employees are made. The payouts are based on a formula that calculates the contributions needed to meet the defined benefit. The formula factors in the employee's life expectancy, normal retirement age, possible changes to interest rates, and yearly retirement benefit amount.
The percentage of U.S. private-sector employees who participated in pension plans in 2019.
The Defined-Contribution Pension Plan
Defined-contribution plans don't guarantee a set benefit amount. Contributions are paid into an individual's account by the employer, the employee, or both. The contributions are invested, and the returns on the investment (ROI) are credited to the employee's account, or debited from it if there are losses. In the U.S. the best-known defined-contribution pension plan is the thrift savings plan (TSP), which is open to federal employees and members of the Armed Services.
The payout from this plan depends upon the success of the investments made for the pension plan. Upon retirement, the member's account provides the retirement benefit, usually through an annuity, and the payments fluctuate with the value of the account.
Defined-contribution plans have become widespread in recent years and are now the dominant form of retirement plan in the private sector in many countries. The number of defined-contribution plans in the U.S. has been steadily increasing, as employers find them to be more affordable than defined-benefit plans.
Starting in 2020–with the passage of the SECURE Act by the U.S. Congress–new rule changes for retirement plans kick in. The new ruling makes annuities within defined-contribution retirement plans more portable, meaning that for those who change jobs, the annuity can be transferred to another retirement plan at your new job.
However, the SECURE Act removes some of the legal risks for annuity providers, such as insurance companies, placing limits on when an account holder can sue the provider if they fail to make the annuity payments.
Also, the Act eliminated the stretch provision for beneficiaries of inherited retirement accounts. In the past, beneficiaries of an inherited IRA could take the required minimum distributions each year, stretching out the length of time that the funds would be depleted. Under the new ruling, non-spousal beneficiaries must distribute 100% of the funds in the inherited retirement account within 10 years of the owner's death. However, there are exceptions to the new ruling as well as other changes. It's important for investors to consult a financial professional to determine if the new rules impact their retirement strategy and designated beneficiaries.