When people are young, they tend to be a bit complacent regarding retirement plans. As they age, planning for retirement naturally becomes a more pressing matter, and people begin wondering what their options are and how to make the best choices for the future.
There’s a lot of information out there regarding retirement and pension plans, and it can be overwhelming for even the most organized and forward-thinking individuals. This article will provide a summary of everything you need to know about pension plans and what you have to take into consideration to make the best choice for your future self and your loved ones.
What Are Pension Plans?
A pension plan ensures that an employer commits to making regular contributions to a fund set aside to make payments to eligible employees after retirement.
In the United States, traditional pension plans (defined-benefit) have become somewhat rare. They’ve been replaced by retirement benefits like 401(k) retirement savings plans. With that said, about 15% of private and 75% of public employees in the States are covered by a traditional pension benefit plan, according to the Bureau of Labor Statistics.
Understanding the Different Kinds of Pension Plans
Typically, a pension plan demands contributions from the employer and can have an additional option that allows contributions from the employee. In most cases, the employee contribution gets deducted from the wages, and the employer has the opportunity to match a part of the worker’s annual contribution up to a particular dollar or percentage amount.
There are two main types of pension plans—the defined contribution and the defined-benefit plan.
The Defined-Benefit Plan
In a defined-benefit plan, the employer must guarantee that the employee will receive a monthly payment after retirement and until the end of their life, no matter how the underlying investment pool performs. This means that the organization is responsible for a specific flow of pension payments to the employee that retires, and the amount in dollars is determined by a formula that takes into consideration earnings and years of service.
Additionally, if the assets in the pension plan are not enough to pay for all of the anticipated benefits, then the company is responsible for carrying out the remainder of the payments.
Defined-benefit pension plans have been around since the 1870s. The American Express Company established its first pension plan in 1875. In the 1980s, the defined-benefit pension plans were at their most popular and covered 38% of all private-sector workers.
The Defined Contribution Plan
If you have a defined-contribution plan, the employer is liable for making a specific contribution for each employee covered by the plan. In such cases, the employee also can match the contribution.
In the end, the benefit received by the employee depends on how the plan performs investment-wise. The company’s liability ends when all of the contributions are expended. The popular 401(k) plan is a type of defined contribution pension plan.
The defined contribution plan can be less expensive for companies in some situations, but the long-term costs are hard to estimate accurately. Defined-benefit plans put the company on the hook, as it has to make up for any shortcomings in the fund. This is why many organizations are now moving to defined contribution plans, like the 401(k).
Different Plan Variations
There are cases when a company might offer both types of plans. They might even allow employees to roll over 401(k) balances into defined-benefit plans.
However, there’s a third variation called the “pay-as-you-go” pension plan. The employer sets them up, and they might be fully funded by the employee, who can opt to make salary deductions or lump sum contributions (things that are not always permitted on 401(k) plans). Besides that, they are extremely similar to 401(k) plans. However, they rarely offer a company match.
You should keep in mind that a “pay-as-you-go” pension plan is nothing like a “pay-as-you-go” funding formula. In the latter scenario, the contributions of active workers are used to fund the ones that currently benefit from the system. Social security is perhaps the best example of a “pay-as-you-go” program.
A Closer Look at the Differences Between a Defined-Benefit Plan and a Defined-Contribution Plan
When we talk about a defined-benefit plan, we talk about a pension plan that guarantees the employees a specific monthly payment that they’re eligible to receive for the rest of their lives after they retire. However, in such scenarios, employees also can opt for a lump-sum payment in a specific amount.
On the other hand, the best example of a defined-contribution plan is a 401(k) or similar retirement plan. In this scenario, both the employee and the employer are allowed to make regular contributions to the account over a few years. After the employee retires, they take over the account, and the company they worked for no longer has responsibility for them.
One thing both plans have in common is that they offer tax advantages for both employees and employers. Currently, the popularity of defined-benefit plans is highest among public sector employers. However, that cannot be said about private employers, which seldom offer such benefits. A few lucky people work for companies that offer both types of plans.
How are Pension Plans Taxed?
Most employer-sponsored pension plans are qualified, which means that they meet the Internal Revenue Code 401(a) and the Employee Retirement Income Security Act of 1973 (ERISA) requirements. This gives them a tax-advantaged status for both employers and employees.
All contributions that employees make come from their paychecks “off the top” of them, which essentially means that they are taken out of the employee’s gross income. This reduces the employee’s taxable income and means they will owe the IRS fewer taxes. Along with that, funds that are put in a retirement plan grow at a tax-deferred rate, meaning that no tax is due as long as the funds remain in the account.
Both types of pension plans allow the employee to defer tax on the retirement plan’s earnings until withdrawals begin. This type of tax treatment enables the employee to reinvest dividend income, interest income, and capital gains, which all generate a much higher rate of return.
When the employee starts withdrawing funds from a qualified pension plan, the federal income taxes are due upon retirement. However, some states will tax that money, too. If you contributed any amount of money in after-tax dollars, then your annuity withdrawals or pension will be taxed only partially.
How to Choose Your Pension Plan?
There are a few things you should consider when you have to pick a pension plan. Let’s see what they are.
Inflation-Adjusted Returns
One of the best factors that you can use to determine which pension plan is the best for your future financial security is to see if the plan offers inflation-adjusted returns. This means that the pension fund you choose has to provide returns that are not affected by the inflation that you will face post-retirement, and so the value of the money must rise along with the rising prices of commodities and goods.
Flexibility
While it’s a good idea to start investing in your pension as early as possible, there’s the chance that as time goes on, you will be able to pay a higher premium as your income increases. That’s why it’s advisable to go for a pension plan that gives you the flexibility to change your contributions through top-ups. Over time, even a slight increase of the premium will make a considerable impact, as it would increase your funds substantially as the year’s pass.
Guaranteed Income Option
Anyone can run out of money, no matter how much you prepare. It’s, therefore, a great idea to find a pension plan that offers you a guaranteed income for life. When looking through pension plan options, you should look for one that guarantees you an income for post-retirement for the rest of your life.
With all that said, when it comes to pension plans, you have to consider your financial situation and your personal life. If you live alone and know that no one depends on you for their well-being, you can pick a plan that comes with a little more risk. On the other hand, if you know that your spouse works a lower income job or doesn’t have any retirement savings of their own, you might need to pick a more secure option that will ensure you both have enough money to live well in the golden years.
Other deciding factors must be taken into consideration in any pension maximization analysis. They include:
- Your age
- Your health and projected longevity
- The projected return for a lump-sum investment
- Your risk tolerance
- Estate planning consideration
In Conclusion
Hopefully, this article gave you critical insights into what pension plans are, why they matter, and how they can make you feel more financially secure after your retirement. If you’re still uncertain about how to set up your retirement plans or how you should invest your nest egg, consult with the Certified Financial Planners at Alpha Wealth Funds to get insight into your options.
Please feel free to reach out to me on this or any of your investment needs or questions. I may not always have the answers at my fingertips, but I promise I will get them for you. Michael Torrence
Calendly link https://calendly.com/mt-awf/intro Work: 435.658.1934 Contact: 330.284.3211
Michael Torrence – Investment Advisor Representative: Michael was born and raised in Ohio and attended The Ohio State University. After College, he was commissioned as a 2ndLt in the United States Marine Corps. He attended his initial training in Quantico, Virginia, then graduated at the top of his Primary Aviator Class and was selected for the Strike (Jet) Platform.
Founded in 2010, our services include boutique hedge funds, separately managed accounts, financial planning, estate & trust services, private placements and in-house concierge services for high net worth individuals, families, and businesses.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. All investments involve risk including the loss of principal.