Pension Plans
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Private pensions, Social Security, and
personal savings are the main sources of retirement income.
Private pension plans are covered by the
Employee Retirement Income Security Act (ERISA), which sets guidelines and
minimum standards for them. ERISA also provides insurance for pension
funds through the Pension Benefit Guaranty Corporation (PBGC). PBGC acts
the same way as deposit insurance at savings institutions. If a pension
fund should fail, the insurance covers retirees and future retirees who
were vested in the fund. However, they may not be fully covered.
Being vested in a pension fund means you
have earned the right to payments from the fund, even though your
employment with an organization may have ended before you reached
retirement age. ERISA provides, under most pension plans, that employees
must be vested according to one of the following schedules: full (100
percent) vesting upon completion of five years of service; or 20 percent
vesting after three years of service, and then 20 percent vesting per year
thereafter until the participant is 100 percent vested after seven years
of service.
Pension plans also credit years of service
differently. Some only start the clock at age 21; therefore, if you
started work at 18, you would have 3 years of service before you started
earning service credit in the pension system. Breaks in service are also
handled differently by different plans. Breaks in service for up to 5
years do not result in any loss of credit; some pensions may allow longer
breaks. Also, many plans stop the clock at age 65 if you work beyond
that age, added years are not credited to your record.
Under the Retirement Equity Act (REA) of
1984, all married pension participants with vested benefits must
automatically be provided upon their retirement with (1) a qualified
preretirement survivor annuity and (2) a qualified joint and survivor
annuity. These annuities must be provided, regardless of the age of the
participant, and can be waived only with the consent of the spouse.
Types of Pension Plans
Generally speaking, there are two types of pension
plans: defined benefit plans and defined contribution plans.
Defined Benefit Plan
For a defined benefit plan, the benefit formula is
set out and contributions are made to the fund so the necessary amount of
money will be there when needed. The amount of the contribution depends on
the interest rate the fund managers think it will earn. During periods of
high interest, contributions can be smaller, since interest will make up a
larger share of money.
Defined Contribution Plan
A defined contribution plan, on the other hand, does
not promise you a specific amount of benefits at retirement. In these
plans, you or your employer (or both) contribute to your individual
account under the plan, sometimes at a set rate, such as 5 percent of your
earnings annually. These contributions generally are invested on your
behalf. You will ultimately receive the balance in your account, which is
based on contributions plus or minus investment gains or losses. The value
of your account will fluctuate due to the changes in the value of your
investments. Examples of defined contribution plans include 401(k) plans,
403(b) plans, employee stock ownership plans, and profit-sharing plans.
Examples of Defined Benefit Plans and
Defined Contribution Plans
Listed below are specific examples of defined
benefit plans and defined contribution plans.
- 401(k) Plans
- Your employer may establish a defined
contribution plan that is a cash or deferred arrangement, usually
called a 401(k) plan. You can elect to defer receiving a portion of
your salary which is instead contributed on your behalf, before taxes,
to the 401(k) plan. Sometimes the employer may match your
contributions. There are special rules governing the operation of a
401(k) plan.
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- Cash Balance Plan
- A cash balance plan is a defined benefit plan
that defines the benefit in terms that are more characteristic of a
defined contribution plan. In other words, a cash balance plan defines
the promised benefit in terms of a stated account balance. The
U.S. Department of Labor, Pension and Welfare Benefits Administration
provides additional information about cash benefit plans.
- Employee Stock Ownership (ESOPs)
- Employee stock ownership plans (ESOPs) are a form
of defined contribution plan in which the investments are primarily in
employer stock. Congress authorized the creation of ESOPs as one
method of encouraging employee participation in corporate ownership.
- Money Purchase Pension
- A money purchase pension plan is a plan that
requires fixed annual contributions from your employer to your
individual account. Because a money purchase pension plan requires
these regular contributions, the plan is subject to certain funding
and other rules.
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- Profit Sharing Plans/Stock Bonus Plans
- A profit sharing or stock bonus plan is a defined
contribution under which the plan may provide, or the employer may
determine, annually, how much will be contributed to the plan (out of
profits or otherwise). The plan contains a formula for allocating to
each participant a portion of each annual contribution. A profit
sharing plan or stock bonus plan include a 401(k) plan.
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- Simplified Employee Pension Plans (SEPs)
- Your employer may sponsor a simplified employee pension plan or
SEP. SEPs are relatively uncomplicated retirement savings vehicles.
A SEP allows employees to make contributions on a tax-favored basis
to individual retirement accounts (IRAs) owned by the employees.
SEPs are subject to minimal reporting and disclosure requirements.
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How Does a Pension Plan Differ From a 401(k)?
A 401(k) plan is a defined contribution plan, which means your
retirement benefit is determined (in part) by how much you and/or your employer
contribute to the plan and the performance of the investment options you choose.
These plans do not guarantee a specific retirement income benefit. Instead, your
benefit is based on your account balance at the time of withdrawal.
A pension plan is a defined benefit plan and provides a guaranteed
level of income at retirement. Your retirement benefit is usually based on a
formula that includes age and years of service. Your employer funds the plan and
makes all the decisions about where to invest the money. The benefits in most
traditional pension plans are protected, within certain limitations, by federal
insurance provided through the Pension Benefit Guaranty Corporation.
What Is a Cash Balance Plan?
A cash balance plan is a hybrid of a defined benefit (such as a pension plan)
and a defined contribution plan (such as a 401(k) plan). Your monthly retirement
benefit is guaranteed, but will be ultimately determined by your account
balance, rather than a preset formula.
In a typical cash balance plan, your account is given an annual credit, which
is, at least in part, based on your salary. You also receive an interest credit.
When you become entitled to receive benefits under a cash balance plan, your
benefits are determined by the ending value of your account. In many cash
balance plans, you have the option to choose an annuity (a fixed monthly payment
for life) or a lump sum. Traditional defined benefit pension plans do not offer
the lump sum feature as frequently.
The benefits in most cash balance plans, as in most traditional defined
benefit plans, are protected, within certain limitations, by federal insurance
provided through the Pension Benefit Guaranty Corporation.
How Does a Change to a Cash Balance Plan Affect Me?
If your employer decides to change from a traditional pension plan to a cash
balance plan, the pension benefits that you have already earned will not
be reduced. According to the U.S. Department of Labor, an employer may change to
a cash balance plan, which may reduce the rate at which future benefits
are earned, but they generally are prohibited from reducing the benefits that
you have already earned under the traditional pension plan. Keep in mind that
your future benefits will not be automatically reduced under a cash
balance conversion. In fact, depending on your employer's plan, you might even
see a larger benefit over time.
Since there are many implications of a cash balance conversion, it is
important that you get as much information from your employer as you can and
study your options carefully. And it's probably a good idea to consult a
professional financial
advisor, who can help determine how these changes could impact your
retirement plan. Additional information about cash balance plans is available at
the U.S. Labor Department's Web site at www.dol.gov.
If I Change Jobs, What Can I Do With My Pension Plan?
If you have been at your company long enough and you terminate your
employment prior to retirement age, you might have the option to receive your
accrued Cash Benefit Plan assets in a lump sum. (Traditional defined benefit
pension plans do not offer this feature as frequently.) If you receive a lump
sum distribution, that distribution generally can be rolled into an IRA or
another employer's plan if that plan accepts rollovers. An IRA might be your
best choice, since it will likely offer more investment options and flexibility.
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