There aren’t many pension plans left in the private sector due to the liability that an employer needs to carry. Pension plans generally require an employer to pay an actuarially determined amount to retired employees or their surviving spouse until death. As a result it requires them to make annual funding mandatory, irrespective of their profits. With longevity increasing and businesses living in a dynamically changing global industrial world, carrying a pension plan comes with a number of financial risks.
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Several employers who earlier had pension plans are now winding them down by rolling them over to 401(K) plans. However, federal and many state governments still offer their employees pension plans. Pension plans don’t offer any in service withdrawals even in hardships (this is different from loan) but 401(k) plans do offer this benefit.
For those who are lucky to have a pension plan, there are 4 different pension plans: defined benefit, cash balance, money purchase, and target benefit plans. These plans broadly fall in two categories: Defined Benefit and Defined Contribution plans. Note that defined benefit is a plan as well as a category of plans.
Defined Benefit or DB Pension Plans:
Defined benefit plans require the employer to contribute money to a general pension account based on actuarial analysis of all its eligible employees. Employee don't have a role in this plan in terms of contribution or management of investments. The maximum annual benefit that someone can get under this plan is currently limited to $230,000. Participant eligibility may be based on age or length of service or both. Benefits are also based on age and length of service. There are 2 defined benefit plans: defined benefit and cash balance plans.
Defined Contribution or DC Pension Plans:
Defined contribution plans require the employer to contribute money to each participant’s account. Employee gets to manage the investment in the account and in some cases are also allowed to contribute as well. Benefits at the time or retirement is based on the account balance of the individual. So, there is no guaranteed benefit unlike defined benefit plans. This is a key difference compared to defined benefit plans. There are 2 defined contribution plans: Money purchase and Target benefit pension plans.
It is the most common defined benefit pension plan and that’s why it takes the name of ‘defined benefit’ category of pension plans. It provides a specific annual retirement benefit at the normal retirement age (65). The benefits are based years of service and compensation level. The annual statement from your pension plan administrator can tell you your expected monthly payout at your retirement age. These plans require employers to contribute funding every year and funding for older employees entering the plan is significantly higher than others. As a result, these plans are more favorable to older employees. There are no employee contributions to these plans. The employer contribution goes to plan’s general account and plan trustee working with the employer and plan administrator decides on how plan funds are invested.
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A DB pension plan is insured by PBGC (Pension Benefit Guarantee Corporation) , a federal government sponsored independent organization. In case a pension plan is terminated by an employer due to bankruptcy or other reasons, PBGC guarantees “basic benefits” earned before the termination date of your plan. It does not guarantee health and welfare benefits. Nor does it guarantee vacation pay or severance benefits. The maximum PBGC monthly benefit for someone with normal retirement age whose pension plan is terminated is in the current year is $4,943 as a straight life annuity. In case of joint and 50% survivor (survivor gets 50% of the benefits), maximum monthly payout is limited to $4,449. Note that PBGC does not protect benefits added to a plan within 5 years before plan termination. The biggest advantage of a DB plan is that it provides maximum retirement benefits if you retire. At the same time, if you leave the employer before retirement, you won’t get a lot in retirement benefits.
In this type of defined benefit plan, instead of contributing to a general plan account, the employer contributes at a pre determined rate (actuarially determined percentage of salary) to hypothetical individual plan participant accounts. The employer is also responsible for a guaranteed minimum rate of return.
The Money Purchase pension plan is a defined contribution plan. Therefore, it has an account in the individual plan participant’s name. The employer contributes a specified percent (limited to 25%) of an employee’s annual salary up to a salary cap of $265,000. Only after tax contributions from employees may be allowed to this plan. The employee is responsible for investment of funds so there is uncertainty on the balance at the time of retirement. You also can’t withdraw any funds prior to retirement, death, disability, or plan termination. However, some plans may have a loan provision. The account balance can be availed in several different ways: as a lump sum distribution, single or joint annuity, or a rollover to an IRA account.
In this defined contribution plan, the employer makes certain contributions to each participant’s account based on the participant’s targeted level of benefit at normal retirement age. The participant is responsible for managing the investments in the account and therefore, bears the investment results.
