What is the Pension Plan?
A pension plan is a retirement plan where the employer makes a guaranteed payment to the employee once they retire. The employee receives a specified income post-retirement every month derived from earnings on its employer’s investments.
The pension amount will typically be a percentage of the employee’s regular salary during their employment with the company. A pension plan is different from a 401k plan in that here employer, rather than the employee, contributes to the retirement funds. However, these plans vary depending on the employer and the employee’s tenure with the company.
- A pension plan is a retirement plan in which the employer will guarantee to pay a specified amount to the employee upon retirement.
- The employer will make contributions on the employee’s behalf and will manage the investments as well. However, an employee may choose to contribute toward the retirement plan in some cases.
- The future pension income depends on how long the employee has worked for the company and how much he or she earned.
- Pension plans and 401k plans differ in several ways, such as contributions, payments, and portfolio management
How Does Pension Plan Work?
Pension plans are typically set up as a defined benefit plan, meaning an employer will guarantee the employee a payment amount once the employee retires. The payments will be consistent, giving the employee a reliable income stream during retirement. These plans are not the same as 401k, although many people confuse them with one another.
Below are the common aspects of pension plans and how they work to give the employee a retirement income:
These plans are employer-funded, meaning the organization will contribute to a retirement portfolio for the employee. It also means that the employee will not contribute to the fund at the employee’s own expense. However, the employee can also contribute to the fund in some cases.
With the contributions on the employee’s behalf, the company will invest in a portfolio containing various securities. The fund’s primary goal is to grow the investments over time and give the company the money needed to make payments to the employee during retirement.
Up until recently, pension funds would almost exclusively invest in safer stocks and bonds. Now the funds will be distributed to an assortment of diverse investments, including:
- BondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.
- DerivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts.
- Real Estate
- CommoditiesCommoditiesA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.
According to research from the National Association of State Retirement Administrators (NASRA), the average pension fund will distribute 47.1% of the fund in public equities (stocks), followed by 24% in fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments. (bonds), 19% in alternative investmentsAlternative InvestmentsA financial asset that is different from the conventional investment categories such as stocks and cash is referred to as an alternative investment. Private equity, hedge funds, venture capital, real estate/commodities, and tangibles such as wine/art/stamps are all examples of alternative investments., 7% in real estate, and 2% in cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. .
In most cases, the size of pension payout depends on the length of time the employee worked for the company and how much they earned during their tenure.
Every plan will have different terms and conditions that apply to them based on what the employer has set in place. However, the pension plan calculatorPension Plan CalculatorPension funds are contributions made by an employer to an employee's retirement. A pension calculator helps determine the eligible amount that the employee is eligible for and is calculated as: AS x F x N, where, AS - average salary per company rules, F - factors in the percentage, n - time. to determine a payout amount will work like this:
(Years Employed * Accrual Rate * Average Salary)
In this case, the Years Employed would be the number of years the employee worked for a particular employer.
The Accrual Rate will be the amount of interest applied, typically a part of the employee’s retirement benefits with their employer. It is a significant factor as it will be multiplied by the total years of employment and the average salary to determine the pension payout. The higher the accrual rate the employee receives, the greater their retirement plan will be.
The Average Salary calculation considers the average salary of the last few years of employment. It could the final three or five years of work, depending on the employee’s location.
For example, an employee worked at a company for 25 years. A standard accrual rate is around 2%, and their average salary was $100,000.
In this case, the pension payout amount would be 25 * 2% * 100,000 = $50,000 a year.
Types of Pension Plans
Although they will vary based on certain conditions, there are two primary types of such plans, including:
#1 – Defined Benefit Plan
- The defined benefit plan will guarantee a set amount of funds upon retirement.
- The employer will make additions to the fund on the employee’s behalf. However, in many cases, the employee can also make contributions.
- Many factors affect payouts, such as years of employment and how much the employee earned.
- The employer will manage the investments in the most plans.
- Payouts will typically last for life after retirement.
#2 – Defined Contribution Plan
- With the defined contribution planDefined Contribution PlanA defined contribution pension plan is when the employer and the employee frequently make a significant amount of contributions to enable employees to save a decent amount of money for the retirement period and leave with the utmost dignity in their retirement phase., payouts vary with several factors, such as how much the employee contributes and how well the investments perform.
- The employee will be making contributions to these types of plans. However, in some cases, the employer can match it.
- The employee will control the investments with a defined contribution plan.
- Payouts will last as long as the money in the fund lasts.
Nowadays, pension plans are not as usual as they once were, partly due to the employer’s contribution. Employers will often offer these plans to lure and keep talent because of the benefits they can offer. These benefits include:
One of the most significant benefits of these plans is the guaranteed payouts once the employee retires. Unlike other retirement plans, these plans do not rely on the performance of any financial market. Instead, these plans will base their payment on the combination of factors relating to employment.
The employer typically manages these plans. It works in most people’s favor as not everyone is a financial expert. With other retirement plans, the employee will have to manage their investments.
If the fund does not perform well enough, the employer may have to step in and contribute. If they go bankrupt and cannot make the payments, an agency like the Pension Benefit Guaranty Corporation (PBGC) will often step in.
Pension Plan vs. 401k
Pension plans and 401k plans401k Plans401k plan refers to a systematic tax-deferred retirement approach whereby the employees can contribute a certain amount towards their retirement savings through the automatic payroll withholding. The employer also contributes an equivalent or lower amount in this plan for the employees' retirement. are two different types of retirement plans that often get mistaken for one another. While the former is a defined benefit plan without employer matches, the latter a defined contribution plan with employer matches. Here are a few key differences between them:
One of the main differences between both the plans is the contributions made. The employer makes the contributions with pension plans, whereas with 401k plans, the employee contributes, and the employer can match it.
With pension plans, the employee guarantees payments after retirement. In 401k plans, the payout will only last as long as funds are there.
Employers will have control over the investments before retirement with pension plans. It is different from 401k plans, where the employee will have control over assets.
This has been a guide to what is a Pension Plan and its definition. Here we discuss how does it work along with types, benefits and its differences from 401K plan. You may learn more about financing from the following articles –