Pensions
A pension is a steady income given to a person (usually after retirement). Pensions are typically payments made in the form of a guaranteed annuity to a retired or disabled employee. Some retirement plan (or superannuation) designs accumulate a cash balance (through a variety of mechanisms) that a retiree can draw upon at retirement, rather than promising annuity payments. These are often also called pensions. In either case, a pension created by an employer for the benefit of an employee is commonly referred to as an occupational or employer pension. Labor unions, the government, or other organizations may also fund pensions.
Occupational pensions are a form of deferred compensation, usually advantageous to employee and employer for tax reasons. Many pensions also contain an insurance aspect, since they often will pay benefits to survivors or disabled beneficiaries, while annuity income insures against the risk of longevity.
While other vehicles (certain lottery payouts, for example, or an annuity) may provide a similar stream of payments, the common use of the term pension is to describe the payments a person receives upon retirement, usually under pre-determined legal and/or contractual terms.
Types of Pensions
Retirement, pension or superannuation plans
By such an arrangement an employer (for example, a corporation, labor union, government agency) provides income to its employees after retirement. Pension plans are a form of "deferred compensation" and became popular in the United States during World War II, when wage freezes prohibited outright increases in workers' pay.
Pension plans can be divided into two broad types: Defined Benefit and Defined Contribution plans. The defined benefit plan had been the most popular and common type of pension plan in the United States through the 1980s; since that time, defined contribution plans have become the more common type of retirement plan in the United States and many other western countries.
Some plan designs combine characteristics of defined benefit and defined contribution types, and are often known as "hybrid" plans. Such plan designs have become increasingly popular in the US since the 1990s. Examples include Cash Balance and Pension Equity plans.
Defined benefit plans
Under 26 U.S.C. § 414(j), a defined benefit plan is any pension plan that is not a defined contribution plan (see below). A defined contribution plan is any plan with individual accounts. A traditional pension plan that defines a benefit for an employee upon that employee's retirement is a defined benefit plan.
The benefit in a defined benefit pension plan is determined by a formula that can incorporate the employee's pay, years of employment, age at retirement, and other factors. A simple example is a flat dollar plan design that provides $100 per month for every year an employee works for a company; with 30 years of employment, that participant would receive $3,000 per month payable for their lifetime. Typical plans in the United States are final average plans where the average salary over the last three or five years of an employees' career determines the pension; in the United Kingdom, benefits are often indexed for inflation. Formulas can also integrate with public Social security plan provisions and provide incentives for early retirement (or continued work).
Traditional defined benefit plan designs (because of their typically flat accrual rate and the decreasing time for interest discounting as people get closer to retirement age) tend to exhibit a J-shaped accrual pattern of benefits, where the present value of benefits grows quite slowly early in an employees' career and accelerates significantly in mid-career. Defined benefit pensions tend to be less portable than defined contribution plans even if the plan allows a lump sum cash benefit at termination due to the difficulty of valuing the transfer value. On the other hand, defined benefit plans typically pay their benefits as an annuity, so retirees do not bear the investment risk of low returns on contributions or of outliving their retirement income. The open ended nature of this risk to the employer is the reason given by many employers for switching from defined benefit to defined contribution plans.
Because of the J-shaped accrual rate, the cost of a defined benefit plan is very low for a young workforce, but extremely high for an older workforce. This age bias, the difficulty of portability and open ended risk, makes defined benefit plans better suited to large employers with less mobile workforces, such as the public sector.
Defined benefit plans are also criticized as being paternalistic as they require employers or plan trustees to make decisions about the type of benefits and family structures and lifestyles of their employees.
The United States Social Security system is similar to a defined benefit pension arrangement, albeit one that is constructed differently than a pension offered by a private employer.
The "cost" of a defined benefit plan is not easily calculated, and requires an actuary or actuarial software. However, even with the best of tools, the cost of a defined benefit plan will always be an estimate based on economic and financial assumptions. These assumptions include the average retirement age and life span of the employees, the returns earned by the pension plan's investments and any additional taxes or levies, such as those required by the Pension Benefit Guaranty Corporation in the U.S. So, for this arrangement, the benefit is known but the contribution is unknown even when calculated by a professional.
Defined contribution plans
In the United States, the legal definition of a defined contribution plan is a plan providing for an individual account for each participant, and for benefits based solely on the amount contributed to the account, plus or minus income, gains, expenses and losses allocated to the account (see 26 U.S.C. § 414(i)). Plan contributions are paid into an individual account for each member. The contributions are invested, for example in the stock market, and the returns on the investment (which may be positive or negative) are credited to the individual's account. On retirement, the member's account is used to provide retirement benefits, often through the purchase of an annuity which provides a regular income. Defined contribution plans have become more widespread all over the world in recent years, and are now the dominant form of plan in the private sector in many countries. For example, the number of defined benefit plans in the US has been steadily declining, as more and more employers see the large pension contributions as a large expense that they can avoid by disbanding the plan and instead offering a defined contribution plan.
Examples of defined contribution plans in the United States include Individual Retirement Accounts (IRAs) and 401(k) plans. In such plans, the employee is responsible, to one degree or another, for selecting the types of investments toward which the funds in the retirement plan are allocated. This may range from choosing one of a small number of pre-determined mutual funds to selecting individual stocks or other securities. Most self-directed retirement plans are characterized by certain tax advantages, and some provide for a portion of the employee's contributions to be matched by the employer. In exchange, the funds in such plans may not be withdrawn by the investor prior to reaching a certain age--typically the year the employee reaches 59.5 years old--(with a small number of exceptions) without incurring a substantial penalty.
Money contributed can either be from employee salary deferral or from employer contributions or matching. Defined contribution plans are subject to IRS limits on how much can be contributed, known as the section 415 limit. In 2006, the total deferral amount, including employee contribution plus employer contribution, was limited to $44,000 or 100% of compensation, whichever is less. The employee-only limit in 2006 was $15,000 with a $5,000 catch-up. These numbers continue to be increased each year and are indexed to compensate for the effects of inflation. The portability of defined contribution pensions is legally no different from the portability of defined benefit plans. However, because of the cost of administration and ease of determining the plan sponsor's liability for defined contribution plans (you don't need to pay an actuary to calculate the lump sum equivalent under Section 417(e) that you do for defined benefit plans) in practice, defined contribution plans have become generally portable.
In a defined contribution plan, investment risk and investment rewards are assumed by each individual/employee/retiree and not by the sponsor/employer. In addition, participants do not typically purchase annuities with their savings upon retirement, and bear the risk of outliving their assets.
The "cost" of a defined contribution plan is readily calculated, but the benefit from a defined contribution plan depends upon the account balance at the time an employee is looking to use the assets. So, for this arrangement, the contribution is known but the benefit is unknown (until calculated).
Despite the fact that the participant in a defined contribution plan typically has control over investment decisions, the plan sponsor retains a significant degree of fiduciary responsibility over investment of plan assets, including the selection of investment options and administrative providers.
