In this article we will be taking a look at pension and pension plan, what pension and pension plan is all about, the pension plan that works, some pension basics and schemes.
What is Pension Plan?
Pension or pension plan, also known as defined-benefit plan is an arrangement offered by an employer which gives an employee regular payments in retirement, usually on a monthly basis.
When the employee is working, the employer sets aside some money which is deposited or transferred into a pension fund account that is managed by the employer. If an employee qualifies for a pension, a specific amount from this fund account is given to the employee as pension when they retire.
Many government agencies offer pensions while private companies usually don't.
A pension plan can also be defined as an employee benefit plan established or maintained by an employer or by an employee organization which provides retirement income or defers income untill the end of the employment. Pension Plan are guaranteed retirement programs that promise workers a specified benefit upon retirement.
They are commonly available to union workers, federal employees, service members and veterans, state and local government employees and other private workers.
Requirements To Qualify for a Pension
Pension is provided to incentivize the employee to stay with the company for many years. The most important criteria to qualify for pension is that, the employee must have worked in the company for a certain number of years.
The amount of money that an employee will receive as pension also depends on variety of factors.
1. The number of years they worked in the company.
2. How old they were, when they retired.
3. Their income when they retired.
Depending on the terms of the pension plan, they may lose some or all of the pension benefits if they quit their jobs before retirement. However, it is important to note that many employers do not offer pension in the first place.
Different Types Of Pension Plan
Are there different types of pension plan? Yes, but the only true pension plan is a defined-benefit plan, where the employee gets a defined amount of money at fixed intervals for their entire life starting from when they retire.
The contributions are mostly or entirely by the employer, who manages the investments and guarantees the payment irrespective of how the pension fund performs. However, because of how expensive these plans can get and the liability to the employer, most of the employers are moving towards what is known as defined contribution plan, where a specific contributions are placed into an investment account by the employer, employee or both parties.
The amount of money the employee receives is dependent on the performance of this investment. One common defined contribution plan is a 401k, where the employee takes on the responsibility of investing and managing the account.
The Downside Of Pension
While on the surface, pension looks like guaranteed free money in retirement and financial security for life but it has it's own risk. First of all, very few employers offer pension. Secondly while it may not be apparentl at least, a part of the money for a pension plan comes out of the employee's salary, which means that they will get less money in their paycheck if the company offers a pension fund.
And unless the employee stays with the company long enough to qualify, they won't get any pension at all. Also if the company goes bankrupt or if the pension plan goes underfunded, the employee won't get the promised amount.
With these reasons above, if your company offers a pension plan, it is best to also save and invest on your own.
The Difference Between A Pension Plan And A 401 (K)
The 401(k)
1. It has a defined contribution plan: A 401(k) is considered as a defined contribution plan because your pension depends on the contributions to your 401(k).
2. It depends on the contributions to your 401(k) account and earnings on investments of those contributions.
3. The employee will receive a balance based on contributions plus or minus the gain or losses on the investment.
Pension Plan
1. It has a defined benefit plan
2. It offers set of monthly benefits, that guaranteed to be received upon an employee retirement.
3. Upon hiring, the employer will commit to sponsoring the pension plan.
How Are Pension Benefits Decided?
The plan could offer a specific dollar amount, (Or amount in your local currency), such as $1500 per month at retirement, or it may calculate benefit through a plan formula that considers factors like average salary and years of service.
Pension Plans are also referred to as defined benefit plans because they are based on a defined formula. The formula multiplies Years of Service (YOS) X The employee's final average salary (FAS) X A benefit "multiplier" or " Accrual Rate" of typically 2% (0.02).
An example of how to calculate a pension benefit plan for Mr Rodney. Let's say Mr Rodney worked for a company for 40 years and he has a final average salary of $85,000. To get the benefit for Mr Rodney's pension, you will have to calculate his guaranteed yearly lifetime income benefit by multiplying the three (3) factors.
That is, 40(YOS) x 2% (0.02)" Multiplier" x $85,000 = $68,000. This means that Mr Rodney will receive $68,000 per year upon his retirement.
Let's say Mr. Rodney worked for 35 years.
That is, 35(YOS) x 2%(0.02) "Multiplier" x $85,000 = $59,500.
As you can see from the illustration above, that the pension plans are mostly used to incentivize employees to at the company for many years. To pay Mr. Rodney's pension benefits, the employer have to set out funds in advance and invest them to cover the retirement payments to it's employees or the employer can pay funds directly from their own pocket.
Many organization oot to create and manage pension fund to ensure there will be enough money to cover employees after there retirement and not run into compliance issues.
However, it is important to keep in mind that most employers are phasing out the traditional pension plans and replacing them with the defined contribution plans, like the 401(K)s. Most employers no longer want to commit to paying employees for the rest of their life because, it can be both expensive and unpredictable.
Defined contribution plans leaves the responsibility of planning for retirement to employees and release employers of that burden.
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