Pension plans can be a significant source of retirement income for many retirees. Employers often use pension plan benefits to attract and retain employees. Typically, they set aside money for each employee in a fund, which the money grows over the tenure of the employee's time there. When employees reach retirement age or retire, they'll receive their pension.
What Is a Pension Plan?
A pension plan is a retirement benefit plan where an employer pays their employee a set amount once they retire or after the termination of their service. The amount will also vary depending on the length of their service.
At retirement, the employee can choose to receive a lump sum or get regular payments for life in the form of an annuity.
To get a pension, an employee needs to put in the minimum time of service, which depends on each employer. They’ll forfeit their right to the pension fund if you leave before that.
Vesting of pension money can be in two forms:
- Cliff vesting: Where they have no claims to the pension fund unless you have completed the specific years of service
- Graded vesting: A percentage of the pension fund gets vested with the employees every year until it reaches 100%
Public vs. Private Pensions
Although employers can offer a pension, it is typically more common in the public sector. The public sector is usually from government bodies, whether state, local, or federal.
Private companies that offer pensions are less common. However, when provided by a private employer, the pension does have legal protections. Private companies are legally required to ensure that they fund their pensions adequately. In addition, the Pension Benefit Guarantee Corporation will insure those pension funds.
Public pension funds are not subject to such legal requirements, which can lead to severe underfunding, drastically reducing such benefits.
Calculating a Pension Fund
A pension can be calculated by:
- Multiplying a fixed dollar amount with the number of years worked.
- Using a formula that considers the employee's final year's salary, accrual rate, and total length of service with the company.
Pension Plan vs. 401(k)
Nowadays, a 401(k) plan has largely replaced the traditional pension plan, especially in the private sector.
A 401(k) is a defined contribution retirement plan where the employee contributes a certain percentage of their salary to the fund that the employer creates. Typically, the employer can either match their contributions partially or fully.
Employees can choose the type of investment plan that they want to fund. Then, they'll be able to make withdrawals once they hit retirement.
In contrast, a traditional pension fund will have funds set aside by the employer once the employee hits retirement. In addition, employees have the option to not contribute to the fund and will receive funds based on the number of years of service.
Although the employer creates the pension fund for the benefit of the employees, the amount is vested in the employees after fulfilling certain conditions.
The main differences between 401(k) and pension funds are:
- Employees are guaranteed pension on retirement
- Employer funds the account
- Employees have no control over the investment of the fund
- Employees may choose to contribute to the plan
- No guaranteed retirement benefits
- Created by the employer and funded with deductions from the employee's salary
- Employees choose their investment plans
- Employers may match the employees' contributions either partially or fully
Risks of a Pension Plan
A pension plan, being a retirement benefit, can have the following risks:
- Since employees do not have control over the fund's investment, a bad investment by the employer can lead to insufficient funds at retirement.
- As pension funds are under the employer's control, they can change the plan's terms, which could lead to reducing the plan's benefits.
- While private pension funds have specific legal requirements, public pension funds do not. Bankruptcy or other economic issues from the government can make a dent in retirement benefits.
A pension fund can be a great retirement benefit if employees plan to stay with their company for the long haul. If they're looking for a fixed income after retirement, a well-invested pension plan from their employer will help ensure a stable financial future.