What is a Pension?
A pension refers to a fixed amount of money to be paid regularly to a person upon retirement.
There are a variety of different types of pensions and benefits, as well as different sources of pensions. There are two primary sources of pensions in the United States, employment-based pensions and state pensions. Employment-based pensions are retirement plans that typically result from both the employer and employee contributing money to a tax deferred savings account. This savings account is allowed to accumulate funds until the employee enters retirement, at which time the funds will become available to the retiree.
Annuities offer a steady stream of income, and the purchase of an annuity is a popular investment to secure retirement income. However, because there are so many different types of annuities, each with their own set of rules and regulations, it is important to educate yourself on the potential risks and benefits of investing in an annuity, or selling an annuity you already own. Follow the links below to become an educated consumer.
Contrary to employment based pensions, state based pensions are administered and regulated by the United States Federal government. The state pension that all United States citizens are entitled to is the Federal Old Age, Survivors, and Disability Insurance program under the Social Security Administration. Social Security is funded through payroll taxes called Federal Insurance Contributions Act taxes (FICA), and the individual’s monthly salary for the prior 35 years of employment determines their Social Security retirement benefits.
Regardless of the source or type, the important thing to keep in mind is that a pension is a pre-established stream of payments or lump sum payment that will support an individual once they have retired from employment.
Types of Employment-based Pension Plans
There are two primary categories of employment-based pension plans, defined benefit plans and defined contribution plans. Whether a plan is a defined benefit plan or a defined contribution plan depends upon how the benefits of the plan are determined.
Defined Contribution Plans
One of the central characteristics of a defined contribution plan is that each employee has an individual account which receives contributions from the employer and/or employee. Typically, employees will contribute pre-tax funds from their salary, and employers match all contributions made by the employee. One important distinction of a defined contribution plan is that contributions made to the account are then invested in the stock market or some other investment vehicle. Gains and losses on these investments are then applied to the individual’s account. Therefore, the risk of the invested funds rests with the employee and not the sponsor of the plan.
Examples of popular defined contribution plans in the United States include Individual retirement accounts (IRAs) and 401(k)s.
Defined Benefit Plans
Defined benefit plans are significantly different from defined contribution plans in that the benefits received upon retirement are pre-established, or defined, by the plan. Furthermore, participants in a defined benefit plan do not have an individual account. Instead, the employer often contracts another party to administer the pension plan for the entire company. The benefits in a defined benefit plan are determined by a formula which often includes the employee’s salary, years of service with the company, age at retirement, and an accrual rate.
One advantage of the defined benefit plan is that because the benefits upon retirement are established by a formula, the risk of investing pension funds falls to the employer. However, as a result of the increased risk to the employer, many companies have switched to defined contribution plans. One criticism of defined benefit plans is that they offer less portability to the employee. Portability refers to the ease of transferring funds from a retirement plan with one employer to another employer in the event that the employee is terminated or changes jobs.