The Different Types of Pension and Retirement Plans | The Legal Protections in Place
A comfortable retirement is a dream for most of us, a time when we can relax and enjoy the fruits of our labor. To do that, though, we need the financial resources. Social security alone may not meet the needs of many Americans. To achieve a greater level of financial freedom in their golden years, workers invest in pension or other employer-sponsored retirement plans.
What Is a Pension or Retirement Plan?
Retirement plans and pension plans are not the same thing. While both involve funding an income for employees starting at some point in the future (when the worker retires), a retirement plan includes contributions by the employee (and perhaps by an employer), whereas a pension plan is an employee benefit funded entirely by the employer.
What Are the Different Types of Pension and Retirement Plans?
Pension plans are categorized as either defined benefit plans or defined contribution plans. A defined benefit promises a fixed monthly payment to an employee upon retirement, typically based on salary and years of service. A defined contribution plan, on the other hand, is essentially an investment account to which the employer makes a specific deposit on a periodic basis during the term of employment. The accumulated principal and any earned interest are then available to the employee at the time of retirement.
Retirement plans come in a variety of forms, but the most common include:
- 401(k)—These plans are generally available through an employer. They allow workers to have contributions withdrawn directly from their pay and made to a limited range of investment options. 401(k) plans generally have high contribution limits and allow for matching of contributions by employers.
- SEP IRA and Solo 401(k)—These are special types of retirement accounts available to small business owners (and their employees) and sole proprietors, with higher contribution limits. Individuals who participate in a SEP IRA or solo 401(k) are considered to be immediately vested, giving them access to funds as soon as contributions are made.
- Individual retirement account (IRA)—IRAs (other than SEP IRAs) are not available through employers but can be used by anyone. We include them here for purposes of comparison to employer-sponsored retirement plans. The annual contribution limits for Traditional and Roth IRAs are lower than for 401(k)s, but the investment options are far more expansive. There are two different types of IRAs:
- Traditional IRA—Contributions to a traditional IRA are tax deductible for the year in which you make them; then, you pay taxes on withdrawals during retirement. In most cases, a person’s tax bracket is lower during retirement than at the time they’re contributing to an IRA.
- Roth IRA— Contributions to a Roth IRA are taxed in the year they’re made and then withdrawals made during retirement are tax-free. Although taxes are not deferred, contributions to a Roth IRA can grow tax-free over the years. In many situations, the benefit of that tax-free growth can be greater than the benefit of tax deferment with a traditional IRA.
What Are the Advantages and Disadvantages of a Pension Plan?
There are a number of benefits to a company-sponsored pension plan:
- The employer has the burden and duty of investing the funds in the pension plan, so you won’t have to spend time and energy following the markets.
- With a defined benefit plan, your employer must assume the risks associated with investing and must make up any shortfall if investments underperform.
- With a defined benefit plan, you will receive a regular payment until your death.
- With a defined contribution plan, your employer must make deposits into your pension account on a regular basis.
There are also some challenges with most defined benefit and defined contribution plans:
- As a general rule, you have little or no control over how the funds are invested.
- You may have difficulty keeping or transferring the benefits if you take a new job.
- Your benefits may be in jeopardy if the company fails or goes into bankruptcy.
- There may be rules in place that make it difficult or impossible to access full benefits until you’ve been an employee for a certain length of time.
What Are the Basic Laws Governing Employee Retirement Plans?
As a general rule, employer-sponsored retirement plans are regulated by federal law. The first major legislation governing pensions was the Employee Retirement Income Security Act of 1974, known as ERISA. Among the basic protections included in ERISA are:
- Mandates that plan participants be provided essential information
- Minimum standards for participation, vesting, funding, and benefit accrual
- Accountability standards for plan fiduciaries
- Guaranteed rights of plan participants to sue for benefits and/or breach of fiduciary duty
- Guaranteed payment of benefits upon plan termination
Another federal law, the Pension Protection Act of 2006, increased contribution amounts to certain plans, allows the conversion of some employment-based retirement assets to personal IRAs, and makes certain benefits available to low-income workers.
How Are Defined Benefit Pension Payments Calculated?
With a defined contribution plan, the participant is entitled to all contributions made by the employer, as well as all growth in the account. With defined benefit plans, the typical computation includes three variables: the employee’s years of service, the employee’s “final average salary,” and a “multiplier.” The final average salary is calculated differently from state-to-state but is typically the average of the employee’s last three- or five-years’ salary. The multiplier, stated as a percentage, then determines the amount of your annual benefit. The typical average multiplier is .02 (two percent), but that number customarily goes up as total years of service increase. As an example, the annual benefit for an employee with 30 years of service, a final average salary of $50,000, and .02 multiplier would be calculated as 30 x $50,000 x .02, giving a $30,000 annual pension during retirement.
The Public Pension Crisis
State and local public pension funds, most of which are defined contribution plans, have been in a state of crisis for a number of years, as their liabilities increase and asset values drop. It’s estimated that the nation’s public pension system lost about one-fifth of its value (roughly $1 trillion) in the first 12 months of the COVID-19 pandemic.
Proposals for reform of the nation’s public pension plans include:
- Lowering the investment-return projections used by plans, which increases the employer contributions required to assure that the necessary funds are available when needed to pay out
- Requiring pension funds to use more realistic and accurate actuarial and mortality rates
- Requiring public pensions to pay down more of their debt earlier