A pension is a regular payment given to retired employees. Pensions are only one part of a retiree’s income, however. Other income sources include Social Security, income from personal retirement savings, and earnings. Many older people continue to work during retirement, especially in the early years of retirement. So consumers planning for retirement need to think about all four sources of income.
Pension benefits are usually paid monthly. People use the terms pension plans and retirement plans to mean essentially the same thing—the term pension plan is used here. Pension plans are divided into two broad types: defined benefit and defined contribution plans.
According to a study by the Employee Benefits Research Institute, in 2008, 67 percent of workers age 16 and over worked for an employer that sponsored a retirement or pension plan. Of these, about half (51 percent) participated in their employer’s retirement plan. Most (55 percent) were in a defined contribution plan; 33 percent were in a defined benefit plan, and about 10 percent were in both defined contribution and defined benefit plans. In addition, more than half of all workers (55 percent) had either a pension plan or other retirement savings in their own individual retirement account (IRA) or Keogh plans. Data from the Federal Reserve Board’s 2007 Survey of Consumer Finances show that 53 percent of workers and retirees have a pension or retirement savings in an IRA or Keogh.
I. Defined Benefit Plans
II. Defined Contribution Plans
III. Cash Balance Plans
IV. How Are Pension Benefits Paid Out?
V. Consumer Protections in Pension Plans
VI. 401(k), 403(b), and 457 Plans
VII. IRAs, SEP IRAs, and Keogh Plans
Defined Benefit Plans
Defined benefit plans are an older form of pension plans. Defined benefit plans define the amount of the pension benefit that will be paid to employees at retirement, and then the employer sets aside funds to pay that future benefit.
Suppose Ann is 25 years old. Her boss tells her that she will pay Ann $12,000 a year in retirement when Ann is 65. Ann’s boss must set aside enough money now to make those $12,000-a-year payments 40 years from now. Ann’s boss will need to estimate what investment return she can earn on the funds and how many payments she will need to make (i.e., how long Ann will be retired).
In some cases, instead of a fixed amount, the pension benefit amount is calculated based on a formula—for example, a combination of worker’s earnings and years of work. Suppose the formula for Sam’s company pension is 1 percent of the average of his earnings for the last three years times the number of years he has worked for the company. Sam’s earnings for the last three years were $40,000, $50,000, and $60,000 (the average is $50,000), and he retired after 30 years of work. The formula is: 1% * 50,000 * 30= $15,000.
Again, Sam’s boss must set aside enough money now to make those $15,000-a-year payments 30 years from now. In addition to estimating the investment return she can earn on the funds and how long Sam will be retired, she will need to estimate how long Sam will work for her and what Sam’s salary will be in his last 3 years of work. With a defined benefit plan, employers are responsible—and bear the risk—for having enough money in the fund to be able to pay for the pension. The actual cost of the defined benefits plan to the employer is uncertain. The cost is only an estimate because the formula depends upon a number of variables, such as the average retirement age, the life spans of employees, the returns earned by any of the pension’s investments, and any additional taxes.
Up until the 1980s, defined benefit plans were the most common type of pension plan. But these plans lost popularity due to their cost and changes in the laws that cover pensions. Also, as workers changed jobs more often, there was a need to have a pension plan that was more portable and could move with the employee from one employer to another. The need to maintain defined benefit plans contributed to the financial woes of companies such as General Motors during the economic crisis of 2008–2009.
Defined Contribution Plans
In contrast to a defined benefit plan that defines the benefit to be paid in the future in retirement, a defined contribution plan defines the amount an employer will contribute into an account for each employee. Employees may be able to choose how the contributions to their accounts are invested; choices can include mutual funds, stocks or other investments, and securities. The returns on the investments, either gains or losses, are credited to the individual employee’s account.
At retirement, the amount of money in the account is used to create the series of payments the retired worker will receive in retirement. With a defined contribution plan, employees—not the employer—bear responsibility for having enough money in the pension account for retirement. If employers contribute enough and make good investment choices, the investments grow and employees will have a large amount in their accounts to use in retirement; if employers make poor choices, employees will not have as much money in retirement.
For example, suppose Ben’s employer tells Ben he will put $1,000 per year into a defined contribution plan. At the end of 30 years, Ben’s employer will have paid $30,000 into Ben’s account. If Ben’s employer chooses an investment that pays 2 percent per year, at the end of 30 years, Ben will have $1,217,042 in his account. If Ben takes out $5,000 per month, his money will last about 30 years. On the other hand, if Ben’s employer chooses an investment that pays 5 percent, at the end of 30 years, Ben would have $1,993,165—or nearly $776,000 more. He could take out $10,700 a month—more than double—and his money would still last 30 years.
Employers can easily calculate the cost of a defined contribution plan, in contrast to the defined benefit plan. Once employees are vested (eligible to receive money) in the plan, most plans are portable—as workers change jobs, they can take their funds with them or roll them over into an individual retirement account.
Defined contribution plans, since their emergence in the 1980s, have shown themselves to be highly successful retirement tools; indeed, they have become the modern standard for U.S. corporations. At the same time, however, participants in these plans can face risks if they are not careful in monitoring their investments. In some cases, in fact, such as that of the collapse of the investment market in 2008, even monitoring may not help. It is estimated that trillions of dollars in savings were lost virtually overnight by owners of retirement accounts (401(k)s, IRAs) when the markets ceased functioning.
Cash Balance Plans
A third type of pension plan—the cash balance plan—is a defined benefit plan, but the benefit that is defined is an account balance, not a monthly benefit. For example, instead of promising workers a pension of $12,000 a year, a cash balance plan would promise a nest egg of $100,000 at retirement. When workers reach retirement, they have a choice of taking a series of monthly payments (an annuity) or taking the entire cash balance as a lump sum. Most traditional defined benefit pension plans do not offer this lump sum payout feature.
How Are Pension Benefits Paid Out?
Most pensions give retirees a choice of how to receive benefits—and how much they receive depends on which option they choose, because some options pay more per month than others. As with the cash balance plan, one option may be to take a lump sum from the plan. Retirees could then invest this amount in an account and then withdraw interest and principal from the account.
Employees may have a choice of how much their monthly benefits will be. Usually, the option that pays the most per month is a single life annuity option. In this payout plan, pension benefits are paid out based on the retiree’s life expectancy. Because women tend to live longer than men, the payout for men is usually higher than for women. Another option is a joint and survivor annuity. The benefits are based on the life expectancy of the retiree and the joint beneficiary of the pension—usually the husband or wife of the retiree. The monthly benefits for a joint and survivor annuity are generally lower than the single life annuity option, because the pension plan has to pay out benefits over the combined life expectancy of two people, which is usually a longer period of time.
Some pension plans provide for benefits to be paid out for a guaranteed number of years, regardless of how long the retiree lives. For example, employees may be able to choose a 20-year certain single life annuity. If an employee retired at age 65 and chose this option, he would receive benefits throughout the rest of his life, even if he lived to be 100. If he only lived until age 75, the remaining 10 years of the 20-year certain payouts would go to a designated beneficiary. The payouts for this option depend on the number of years of guaranteed payouts and are generally lower than those for the single life annuity but higher than payouts for the joint and survivor annuity.
Not all pensions adjust to accommodate cost-of-living increases—an important feature to consider in planning for retirement income. Suppose a pension paid out $1,000 a month, with no cost-of-living adjustment. If prices rise 10 percent over five years, it would take $1,100 to buy the same goods and services that once cost $1,000, but the pension stays at $1,000. Retirees would need to have some other source of funds, such as other retirement savings or IRAs, to maintain their purchasing power.
Consumer Protections in Pension Plans
The major federal law that provides consumers rights and consumer protections for their pensions is the Employee Retirement Income Security Act (ERISA). For example, ERISA sets out the maximum vesting period—how long employees need to work for an employer before they have a right to a pension that cannot be taken away. There are two vesting options for pension plans. The first option, called cliff vesting, provides employees with 100 percent of their benefits after five years of service. If an employee leaves after only four years of work, she will have no pension.
The second option provides for graduated vesting; employees earn a right to 20 percent of their benefits after three years, and then increases of 20 percent per year (40 percent after four years, 60 percent after five years, 80 percent after six years), so that after the seventh year, employees have rights to 100 percent of their benefits.
What happens if the company goes out of business—and the pension that workers were counting on goes away? ERISA also created the Pension Benefit Guaranty Corporation (www.pbgc.gov), which ensures pension benefits for workers. The drawback is that the benefit amounts retirees receive from the PBGC may be less than the pension benefits they were expecting—so they have less money in retirement. (And PBGC was itself hit hard by the recession but remains properly funded.)
ERISA also requires that if a retiree chooses a single life annuity option, the spouse must cosign the benefit selection form. This provision came about because many retirees were choosing single life annuity options, which paid more while the retiree was alive but left their spouses with no pension income. In an era when many women were not employed outside the home, this made a lot of sense—without a pension, many widows had to survive only on Social Security.
401(k), 403(b), and 457 Plans
A 401(k), 403(b), or 457 plan is an employer-sponsored retirement plan that allows employees to set aside some of their current earnings as personal savings for retirement. Employees do not pay taxes on these earnings until they withdraw them in retirement, when their tax rate may be lower. The numbers refer to the sections in the Internal Revenue Service tax code that apply. The 401(k) applies to most workers, while a 403(b) plan covers workers in educational institutions, religious organizations, public schools, and nonprofit organizations; 457 plans cover employees of state and local governments and certain tax-exempt entities.
Neither benefits nor contributions to these plans are defined. Employees choose how much to contribute (up to limits set by the IRS) and how to invest the money. Workers over age 50 can contribute extra money into a catch-up fund for retirement. If employees move to a different job, they can roll over the money into an individual retirement account, or they may be able to move the assets into the new employer’s 401(k) plan.
Employers may match worker contributions—an important benefit to think about when one is looking for a job. Consider Matt and John. Both work for Mega Corporation, which provides a match of up to 5 percent in the company 401(k). Both make $40,000 a year. Matt does not participate in Mega’s 401(k), so his taxable salary and total compensation are $40,000. John, on the other hand, contributes 5 percent to his 401(k). His pay is reduced by $2,000, so his taxable salary is $38,000 instead of $40,000. But Mega Corp. adds a matching 5 percent—$2,000—to his 401(k) fund. So John’s total compensation is his $38,000 pay plus the $2,000 he puts into his 401(k) plan plus Mega’s $2,000 contribution to his 401(k)—or a total of $42,000.
Some employers have opt-in 401(k) plans and others have opt-out or automatic enrollment plans. For automatic enrollment plans, employers set an initial contribution rate and investment option. In either case, employees can choose how much to contribute and how to invest the money to tailor it to their specific needs.
IRAs, SEP IRAs, and Keogh Plans
Individual retirement accounts are self-directed retirement accounts—workers choose how much to contribute and how to invest the money. Money contributed to an IRA must come from earnings, although spouses not employed outside the home are allowed to put money into an IRA as well. There are three kinds of IRAs: pretax IRAs, posttax IRAs, and Roth IRAs.
Contributions to a pretax IRA are restricted to people without other pensions and are subject to income limits set by the IRS. Taxes on the money put into the account and taxes on any interest or gains are deferred until retirees withdraw the money. Almost anyone can set aside money in a posttax IRA, again subject to IRS limits for annual contributions. When retirees withdraw the money, they pay taxes on the earnings but not on the principal.
A Roth IRA is a special kind of posttax IRA; contributions are limited by income, but all withdrawals are tax-free. Money invested in any of theses types of IRAs is usually put into securities, particularly stocks, bonds, and mutual funds.
SEP IRAs, simplified employee pension plans, are usually used by small businesses that want to provide their employees with some retirement funding. Employees set up their own IRAs and employers can contribute to these accounts.
Keogh plans are for self-employed individuals and their employees. These plans receive special tax treatment like a tax deferral on contributions and earnings until workers retire and start receiving benefits.
The Internal Revenue Service has special rules about money in IRAs, which it enumerates in IRS Publication 590 (available at http://www.irs.gov/pub/irs-pdf/p590.pdf). If workers withdraw money before age 59 1/2, they have to pay taxes on that money as well as a 10 percent penalty. Also, workers must start withdrawing funds by age 70 1/2, and there are specific minimum withdrawals required under tax law.
There are more options, and therefore more choices, for retirement planning today than in the past. The days of working without having to worry about retirement are long gone (if, indeed, they ever existed in the first place). Especially as more people change jobs over the course of their careers, taking advantage of options for accumulating funds for retirement becomes even more important.
Many commentators on both sides of the political spectrum welcome the range of retirement options and find that a mix of corporate and individual responsibility is the best means for satisfying the working public’s retirement needs. Critics on the right (i.e., conservatives and libertarians) generally prefer that businesses not be unduly burdened with providing for the retirement security of their employees; they emphasize the need to shift pensions in the direction of individual savings and investment accounts. Critics on the left (i.e., liberals and social democrats), on the other hand, tend to prefer that businesses contribute significantly to the retirement security of their employees; they argue that personal retirement accounts are not for everyone. Where the pendulum rests at any given moment depends on many factors, both economic and political.
Jeanne M. Hogarth and Michael Shally-Jensen
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