Pension Plan - Explained
What is a Pension Plan?
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Table of ContentsWhat is a Pension Plan?Types of Pension PlanERISA and Pension PlansVesting of a Pension PlanAre Pension Plans Taxable?Changing a Company Pension Plan?Pension Plan vs Pension FundsAdvantages and Disadvantages of Pension PlansMonthly Annuity or Lump Sum?Yield on a Pension PlanCalculation of a Pension AmountRetirement and Defined-Contribution PlansAcademic Research on Pension Plans
What is a Pension Plan?
A pension plan refers to a retirement fund where an employer contributes into an account that has funds for offering retirement benefits to his or her employees. The employer invests these funds on behalf of employees or workers, and the income received from such investments keeps on being accumulated until the employee or worker retires. Besides contributions made by the employers, there are some pension scheme plans that involve making voluntary investments by employees. They can invest a certain portion of their wages or salaries into an investment fund so as to grab bigger amount at the time of retirement. Also, the employer can also try to meet a specific percentage of the yearly contributions made by the workers or employees.
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Types of Pension Plan
Pension plans are of two types: A defined-benefit plan involves an employer making a promise to his or her employee to offer a certain amount at the time of retirement, irrespective of the overall functioning of the investment. Here, it is the responsibility of the employer to proffer a certain amount of pension to the retiree. Such amount is calculated by considering years of employment and earnings. If the pension plan doesnt have sufficient assets to pay the retiree, the company itself becomes liable for paying the remaining amount. The first pension plan was established by the American Express Company in the year 1875, and by the 1980s, the employer-sponsored pension plans were able to offer retirement benefits to almost half of the workers employed in the private sector. As per the latest Bureau of Labor Statistics, around 90% of employees working in the public sector, and 10% in the private sector get covered by a specific pension plan. The second type involves defined-contribution plans where the employer contributes specific funds to the employees account. This amount generally correlates with the extent of contributions the employees or workers make. Depending on how good the investment plan performs, the employee receives the ultimate benefits. The company becomes no more liable once the employer makes the defined contributions. There are lots of private firms that prefer to invest in this specific pension plan because of it being less expensive. The companies are not bound to pay employees out of their own funds, unlike the defined-benefit pension plan. One of the most famous defined-contribution plans are the 401(k) and 403(b) for non-profits employees. Generally, a pension plan relates to the conventionally used defined-benefit plan, involving a specific amount of contributions made by the firms employer. There are companies who prefer to use both plans. They also let workers to roll over the balances of their 401(k) contributions in their defined-benefit pension plans. Another form of pension plan solely managed by the employee includes the pay-as-you-go pension plan. Here, the employee completely contributes the amounts, either in a lump sum or through salary deductions. Though these plans are same as 401(k) plans, they dont offer any organizational match.
ERISA and Pension Plans
In order to safeguard the retirement assets of employees or investors, a special act called the Employee Retirement Income Security Act (ERISA) was created in the year 1974. Further, it sets standards that institutions maintaining retirement plans need to abide by in order to keep the assets of private sector workers safe. Organizations, offering retirement plans, are known as plan sponsors or fiduciaries. ERISA asks every firm to offer a certain extent of plan information to eligible workers or employees. Fiduciaries offer insights on what investment alternatives are available, and the dollar value of contributions made by the employees that are further matched by the firm, if required. Employees are also required to know the concept of vesting that includes the dollar value of the pension assets that an employee owns or possesses. Many factors such as the tenure of employment affect the vesting.
Vesting of a Pension Plan
During the first year of employment, an employee automatically gets registered in the defined-benefit pension plan. However, vesting can take place immediately, or be allocated to around 7 years. An employee receives a few benefits, and in case, he or she chooses to leave the company, it may cause him or her to forego all or a few benefits covered under the pension plan. Defined-contribution pension plans consider complete vesting of employees contributions the time they are in your account. However, if the employer tends to meet those contributions or includes company stock in your benefits plan, it can organize a timeline that will ascertain a specific amount offered to you every year until you become completely vested. Even if contributions made for the retirement plan are 100% vested, it doesnt mean that you can withdraw amount whenever you want.
Are Pension Plans Taxable?
Majority of the employer-sponsored pension plans comply with the standards of Internal Revenue Code 401(a) and Employee Retirement Income Security Act of 1974 (ERISA). And such compliances offer them tax-related benefits. Employers who contribute to employees retirement funds receive tax exemptions. Also, contributions made by employees are excluded from their pay stubs, and hence, ruled out from their gross earnings, which ultimately results in lower income that needs to be taxed, and hence, lesser amount owed to the IRS. Contributions made in a retirement pension plan increase at a tax-deferred rate, which means that they are free of taxes till they stay in the account. Both of these plans permit employees to defer taxes on the earnings related to retirement plan until they start withdrawing. This ultimately motivates employees in further investing the income received in the form of dividends, interest, and capital gains, that leads to having larger accumulated yields before they retire. Once you retire, and begin receiving pension on a monthly basis, you may be liable for incurring federal and state income taxes. If an employee didnt contribute anything for his or her retirement plan, or the employer gave you all of your contributions without deducting any taxes in the previous set of years, you need to pay the whole amount of tax on your pension. In case, you made contributions post tax payments, a part of the pension you receive becomes taxable. You dont have to pay taxes on the contribution that is the yield of the post-tax amount you invest in the plan. Simplified method is used to ascertain taxes for partially taxable eligible pensions.
Changing a Company Pension Plan?
There are many organizations sticking to the conventional defined-benefit plans. This prevents workers from receiving higher yields irrespective of the time period they serve in the organization, or the extent of increase in their salary. When the party sponsoring the pension plan wants to make any changes in the plan, the employees involved get a credit for any eligible activity that took place before such changes were made. However, it depends on the nature of plan to assess how much of the previous work needs to be included or covered. After this, the plan provider needs to cover such costs in a retroactive manner for every employee in a just and reliable manner for their remaining employment tenure.
Pension Plan vs Pension Funds
Pension fund refers to a defined-benefit plan that consists of the cumulative contributions made by employers, unions, and other firms. A financial intermediary operates and regulates pension funds, and expert fund managers have the responsibility of managing them. Pension funds gather and manage a huge amount of capital and exhibit the biggest institutional investors from many countries. Also, they have a huge influence on the stock markets where they have been invested. Pension funds dont involve any tax on capital gains. Earnings obtained from the investment portfolios dont involve any tax restrictions either.
Advantages and Disadvantages of Pension Plans
With a pension fund, employees know that they will be receiving a set amount of money as pension upon retirement. This further helps them in ascertaining their budgets and setting their spending powers. It is the duty of the employer to contribute mostly to the pension fund. He or she cannot minimize the benefits that an employee is ought to receive after retirement. Also, employees can also make some contributions based on their will. As these benefits have nothing to do with asset returns, they will have stability even in the fluctuating economic scenario. As compared to a defined-contribution plan, it is possible for a firm to make more contributions to an employees pension fund, and have more tax exemptions. It also enables to sponsor retirement in advance so as to market significant organizational strategies. Amongst other schemes, a pension plan tends to be more complicated and expensive in terms of organization and management. Employees cannot take part in making investment-based strategies. Also, firms are liable excise tax in case the fund doesnt meet the minimum requirement in terms of money, or exceeds the stipulated amount. The salary of an employee as well as the number of years he or she works for a company has a direct influence on his or her payout. One cannot use a pension fund for making withdrawals or taking loans. During the course of service, one cannot have these funds before they are 62. If you retire early, it is possible that youll be handed with less pension per month.
Monthly Annuity or Lump Sum?
A defined-benefit plan comes with two different distribution methods: receiving monthly or recurring payments throughout your life, or getting a lump sum amount. There are some plans that let retired employees use both methods, that is to have a lump sum amount of money, and receive a monthly pension from the remaining amount. Whether you choose either of the options, or both, you cannot alter your final decision. A lot of things need to be considered when it comes to selecting between a lump sum and a monthly annuity: Annuity: Monthly annuity is paid in the form of a single life annuity for the remaining life of the person,or in the form of a joint and survivor annuity that is created for both the employee and his or her spouse. The joint and survivor annuity generally needs to shell around 10% less as compared to single life annuity. However, the survivor starts receiving payouts after the retired employees death, and he or she continues to receive it until their death. There are some individuals who prefer receiving single life annuity, and go for buying a life insurance cover for making their spouses life easier afterwards. After the employees death, the spouse gets a huge payout as death benefit that is free from any taxes. They can further invest this amount somewhere, and this amount can be a substitute for the pension that is taxable, and has ceased to exist. This approach, known as pension maximization strategy, works well if the insurance costs tend to be less than the payouts received from single, and joint and survivor policies. In several situations, the costs go beyond the benefits received. Is it possible for your pension fund to be out of funds? In theoretical terms, YES. But in case, you dont have adequate money in your account, the Pension Benefit Guaranty Corporation will contribute a proportion of annuity on a monthly basis, up to an amount specified by law. As per the latest 2019 laws, the maximum benefit that a 65-year old retired person can receive is $67,295 per year. However, such amounts would not exceed the amount that you would have received from the actual pension plan. Annuities generally offer fixed payouts. Also, some of them include coverage from inflation, while others dont. The latter involves the amount that you receive from the time you retire. This will have a negative correlation on your payments real value. Depending on the living expenses, that hardly decrease, there are many retirees who opt for taking the lump sum amount. Lump sum: When you opt for taking a lump sum payment, you nullify the chances of losing a portion or a whole of your pension amount, in case the company becomes bankrupt. Also, you can invest this amount in different projects, and earn a return rate thereon. In case of death, your nominees can receive the remaining chunk of money in the form of your estate. However, considering the negative side, one cannot receive the income throughout the lifetime. It is up to the user to ascertain for how long he or she would like to use the money. You must invest the lump sum amount into an IRA or other accounts that will save you from paying more taxes. In case, a public-sector employer maintains your defined-benefit plan, then the lump sum amount will be equivalent to the contributions made. In case of contributions made by the private-sector employer, the lump sum amount will be equal to the present value of the annuity. You can prefer using a lump sum allocation for buying immediate annuities by yourself, that could offer you income on a monthly basis, and save you from inflation. Since youll be buying it on your own, the income you receive wont be as big as the annuity from the defined-benefit pension plan.
Yield on a Pension Plan
For knowing which pension plan gives you more payouts, you just need to rely on some assumptions and simple calculations. Employees know the present value of a lump-sum payment. However, for estimating the financial essence of the financial plan, it is necessary to know the present value of annuity payments. For knowing the discount or prospective rates of interests for annuity payments, identify where you would like to make investment of lump sum payment, and how you would utilize the rate of interest for discounting back the annuity payments. The feasible way to choose the discount rate would be based on the assumption that the person receiving the lump sum would invest the payout in a diversified manner with 60% in equity, and the remaining 40% in bonds. The discount rate would appear to be 7.40% considering the historical average of 9% for stocks, and 5% for bonds. For instance, Sarah is given the option of choosing between $80,000 that she receives today, or $10,000 that she will continue receiving every year for 10 years. Here, the choice is between $80,000 vs $100,000. Go for the annuity. However, the expected rate of return or discount rate will have a direct impact on the decision. Sarah wishes to go for $80,000 rather than the 10-year annuity. The present value of annuity payments is $68,955.33 today (after applying the discount rate of 7.4%) which is less as compared to the lump sum amount of $80,000. As $80,000 is more than $68,955.33, Sarah would prefer choosing the option of receiving the lump-sum payment.
Calculation of a Pension Amount
Several factors that need to be considered for maximizing the pension amount are as follows:
- Age: A 50-year old person, when accepting a lump sum, runs a higher risk than the 67-year old. People who decide to go for a lump sum at a young age experience more unpredictability in terms of finance and other factors than the ones who opt it later.
- Health and life sustenance: If your ancestors have a history of dying in early 70s or late 60s, then you may prefer receiving the lump sum amount. In case, its the opposite, meaning you have a life expectancy of 90 years, then you will opt for pension. It would be good to know that majority of the lump sum payouts are ascertained on the life expectancies of employees. This means the persons who manage to live beyond the anticipated age would go beyond the lump sum payout. Also, you may check if your pension payouts offer health insurance cover too.
- Financial situation: If your financial status is not that good, you may need the lump sum payout. Also, the tax bracket that your income falls in also tends to be a significant factor. In case, you fall anywhere in the high paying tax brackets, any bill from Uncle Sam on the lump sum payout can prove to be disastrous. If you have a huge mortgage to pay for, you can use the lump sum amount in paying off the mortgage, or any other obligations and save yourself from additional interest rates. Employees who have an intention of offering continued services at another organization, can also go for a lump-sum payout, and can convert the amount into an exclusive scheme.
The anticipated return from the lump sum amount invested: If you are able to ascertain the returns that youd receive from your investment portfolio that are almost equal to the amount you would be receiving from your pension fund, you should go for the lump sum. Obviously, you are supposed to use a feasible payout factor like 3% and include a drawdown risk in your calculations. The present market scenario and rates of interest will have a huge impact, and you must ensure that the portfolio meets your risk obligations, time period, and particular investment goals. Safety: People who are resistant to risks, or find yourself uncomfortable managing huge amounts of money, should go for annuity payout. If a company becomes a victim of bankruptcy followed by the PBGC safety, state reinsurance funds ensure to offer indemnity of around $200,000 to $300,000 to all customers. Life Insurance Cost: If you have a healthy lifestyle and are less prone to health issues, then buying a universal life insurance policy would make a great deal. It wont just balance out the loss that prospective pension income would have, but will also offer you a big portion of money that you can invest somewhere else. Such policies can also offer several benefits for chronic treatments, or home care. In case, you are not medically insurable, then you may opt for the pension. Inflation protection: The pension payout scheme offering a cost-of-living hike on yearly basis is better than the one that doesnt. If you dont consider the inflation protection feature in your pension plan, then you must be prepared for arranging other sources of income so as to support your present lifestyle. Estate planning consideration: You can not choose annuity in case you want to transfer your legacy to your nominees or children. Such plans stop offering payouts once the retired person, or the spouse expires. If you stick to the pension payout, then make sure to contribute a specific percentage of that income to a life insurance policy.
Retirement and Defined-Contribution Plans
At the time of retirement, you get various alternatives to choose with a defined-contribution plan:
- Leave In: You can leave the money as it is, and dont make any withdrawals. Sometimes, the organization will ask you to do so. This will help you in getting tax-exemptions on the contributed amount. As per the required minimum distribution rules of IRS, the person should start withdrawing money after 70.5 years. It can be an exception in case the employee of that age is still working for the organization.
- Installment: With the help of installment payments or income annuity, you can manage having your own income stream. This seems to be like awarding yourself throughout post-retirement. In case, you are planning to annuitize, make a note that the expenses would probably be more as compared to an IRA.
- Roll Over: You have the option of rolling over the 401(k) amounts to a conventional IRA where you wont experience any tax issues. This will help you in benefitting from several investment alternatives. Then, you have the option to convert at least some portion of IRA to a Roth IRA. Also, you can convert your 401(k) into a Roth IRA without any fuss. In both situations, youll be incurring taxes on the amounts you convert in that very year. However, you can make withdrawals from the Roth IRA without worrying about taxes. Also, with the Roth IRA, there is no specific age limit when you need to start withdrawing money. You can keep the entire amount in the account as long as you want.
- Lump sum: When you prefer going with a defined-benefit plan, you have the option to get a lump sum amount. After incurring taxes, you can make investment as per your preferences. However, remember that you may have to bear higher taxes when dealing with a lump sum amount. The amount of tax will depend on how big your lump sum amount is.
Academic Research on Pension Plans