Pros And Cons Of Private Pension Plans

By Ronald Kimmons. May 7th 2016

A pension is a program set up in which the beneficiary receives a certain amount of money in regular installments after having retired from an occupation or service. In the United States, the federal government provides a mandatory [|]pension program[:|] – to which all working people are required to contribute – in the form of Social Security.

However, for many, the benefits provided by Social Security may not appear sufficient. As a result, they prefer to make contributions into private pension plans as well. Such plans come with their own advantages and disadvantages relative to public plans. In the United States, private pension plans come in two basic types: [|]defined-contribution plans[:|] and [|]defined-benefit plans[:|]. As the names of these plans suggest, the first is characterized by having a certain amount or percentage of earnings set aside to invest into the employee’s pension, while the second is characterized by guaranteeing a certain payment amount upon retirement.

[Related: 5 Important Tips To Save For Retirement]

Pro: Optional Nature

With public pension plans, working people are usually required to contribute a certain amount of their income, regardless of whether they want to or not. However, with private pension plans, working people may choose to opt-in or opt-out. Those who choose not to participate in the pension plans provided by their employers often do so because they feel that they can get a better deal elsewhere. Usually, this means active investment management instead of paying into an investment fund that manages contributors’ investments for them.

Pro: Projected Returns

The principal virtue of private pension plans is that they tend to outperform comparable public plans. This is largely because, as is the case in the United States, the contributions made into public plans are frequently used to provide benefits to those who never contributed a significant amount. While such practices may be beneficial to society as a whole, they are somewhat detrimental to those who contribute significant amounts of money to the programs.

Pro: Flexibility

Another benefit of private pension programs is that they often allow for a higher level of flexibility. In any investment opportunity, risk is going to be inversely related to opportunity. Low-risk investments tend to bring low returns, while [|]high-risk investments[:|] have more of a tendency to result either in higher returns or losses. Private pension plans often allow participants to select from an assortment of risk levels, giving them the opportunity to possibly gain more on their contributions.

Pro: Less Benefit Limitations

Another issue associated with public pension plans is that they tend to have a number of limitations related to benefits. For instance, in the United States, there are limitations to the benefits you can receive if you receive Social Security benefits before full retirement age. Those who work and earn more than $14,460 prior to reaching full retirement age lose $1 in benefits for every $2 they earn above that limit. (However, this limitation does not apply to those who have reached full retirement age.) Private pensions, however, are not saddled by such limitations. They usually require beneficiaries to reach a certain age and stop working for the company full-time, but they do not take income from other employers into account.

[Related: What Is The Best Age To Start Collecting Social Security Benefits?]

Pro: Relationship With Public Plans

While the amount of money a working person makes in normal wages can decrease his or her current benefits from Social Security or comparable public pension plans, benefits from private pension plans do not affect public pension benefits in this way. Your Social Security benefits will not decrease if you receive distributions from a private pension plan.

Con: Portability

While private pension programs tend to have many advantages, there are some disadvantages associated with them. One is the matter of [|]portability[:|]. While the benefits for public pension plans tend to continue accumulating regardless of who the employer is, private pension plans often do not.

If someone works for a particular company for 15 years and then goes to work for a different company, then that person will lose private pension benefits. This is because pension benefits are often based on tenure. In some cases, private pension plans are portable between specific employers, but such situations only exist as a result of agreements made between companies. While governments can take certain measures to make private pensions more portable, doing so is problematic because such action would increase costs for employers.

Con: Tax Issues

A common misconception that people have is that private pension benefits are untaxed. On the contrary, pension beneficiaries do have to pay [|]income taxes[:|] on what they receive, either in full or in part. The specific taxation levels they face depend on various variables. One such variable is personal age. Private pension plans do not face the same age-based limitations as public plans: beneficiaries can collect on them as soon as they want, within the constraints of their specific plans.

However, if you are a resident or citizen of the United States and you receive distributions from your pension before the age of 59 ½, the Internal Revenue Service will levy a 10 percent tax on these distributions – on top of whatever other taxes you must pay. Even after the age of 59 ½, your benefits are still taxed. The extent to which they are taxed depends largely upon whether or not your contributions were made in after-tax dollars. Benefits resulting from before-tax contributions are subject to higher taxation than benefits resulting from after-tax contributions.

Con: Opportunity Cost

The main disadvantage of participating in a private pension plan is that the money you contribute to it could be used for other investments. The possibility for wealth accumulation in a private pension program is always going to be less than what one would be able to find through active investment. Putting money toward a private pension plan reduces one’s ability to engage in active [|]personal investment[:|]. However, such investment usually requires a significant amount of research and risk that goes above and beyond what pension plans require.

Bottom Line

Private pension plans have their advantages and disadvantages. For most people, contributing to a private pension plan in addition to whatever contributions they are required to make to public plans is a smart and safe way to prepare for retirement, as the benefits resulting from public plans may not be sufficient.

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