A pension plan is an employee benefit plan established or maintained by an employer, an employee organization, or both, which provides retirement income or defers income until termination of covered employment or beyond. The payment is based on pre-determined legal and/or contractual terms. In the US, retirement plans are defined in tax terms by the IRS code and are regulated by the Department of Labor's Employee Retirement Income Security Act (ERISA) provisions. There are different types of pension plans like the 401(k) plan, Simplified Employee Pension Plan, and more.
How It Works
ERISA covers two types of pension plans including defined benefit plans and defined contribution plans. A defined benefit plan is an employer-sponsored retirement plan, in which employee benefits are sorted out based on factors such as salary history and duration of employment. In a defined contribution plan, the employee or the employer (or both) contribute to the employee's individual account under the plan, sometimes at a set rate of earnings annually. Since its inception in 1978, the 401(k) plan has gained popularity in America due to its relative flexibility. In a 401(k) plan, an employee can choose between taking compensation in cash and deferring a percentage of it to an account under the plan. 401(k) plans are a type of defined-contribution plan, so a participant's balance is based on the contributions made to the plan and the performance of plan investments. Employers are not required to contribute to this plan, but can do so if they want.
Benefits are based on the type of pension plan chosen. In the case of a defined pension plan, benefits are fixed and not dependent on asset returns. Even if you retire early, this plan gives you substantial benefits. 401k plans can be subject to IRS 5500 filings, permit loans and hardship withdrawals, and more.
All these pension plans offer significant tax advantages.
An actuary or actuarial software is required to calculate the costs of a defined benefit plan as it involves a complicated process. It is, however, always an estimate because it has to be based on assumptions of economic and financial considerations. Factors that go into these assumptions are: the average retirement age and lifespan of the employees, the returns to be earned by the pension plan's investments. and any additional taxes or levies. So the benefit is secure, but the contribution needs to be calculated by a professional. The "cost" of a defined contribution plan can be 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, in this case the contribution is known, but the benefits are relatively unknown.
Mostly the employer and employee contribute towards these pension plans, but funding can also come from labor unions, government agencies or self-funded schemes. Companies with strong pension plans include: Phillip Morris, a tobacco company, Schering-Plough, a pharmaceutical company, Phelps Dodge, a mining company, and Chevron gas station.
The sooner you start saving for your future, the more financially comfortable you will be after your retirement. If your company doesn't provide a comprehensive pension plan, then now is the right time to invest in one.