Facts You Should Know About A Pension Plan

A pension plan is a benefit enjoyed by an employee that commits an employer to make regular contributions to funds set aside for payments eligible to employees when they retire.

Traditional pension plans have been highly replaced by retirement benefits in most of the United State’s private sectors. This is because retirement benefits are less costly to employers.

According to the Bureau of Labor Statistics, approximately 15% of private employees and 83% of employees in public sectors in America are covered by the traditional pension plans currently.

Types Of Pension Plans

Pension plans exist in two main types. They include:

1. The Defined Benefit Plan

Here, the employer guarantees their employee that they will get a certain monthly payment when they retire, which will be for a lifetime. This will be regardless of the performance concerning the investment pool.

The employer is liable for a fixed flow of contributions to the employee retiring for pension payments. The plan is determined based on calculating the years of service and earnings. This type of pension plan dates back to the 1870s, and American Express was the first company to establish a pension plan in 1875.

2. The Defined Contribution Plan

Here, the employer makes a particular contribution for every worker covered by the contribution plan. The employees’ contributions sometimes match it.

The end benefits an employee receives will depend on the plan’s investment performance. The liability of the company will end if the total contributions are exhausted.

This type of pension plan is less costly for the employer or company. However, it is difficult to accurately estimate the long-term costs. The defined contribution plan ensures the company makes up for any shortfalls in the pension payment.

These are part of the reasons why there is a growing number of employees in the private sector who are moving to this pension plan.

Are Pension Plans Taxable?

Most pension plans are qualified, which means they meet the requirements of (ERISA) Employee Retirement Income Security Act of 1974 and Internal Revenue Code 401 (a).

By this, pension plans usually have tax advantages for employees and employers. Contributions to ensure this is cut from the gross income of employees. Thereby it effectively reduces the taxable income of employees and the money owed to the IRS on tax day.

Moreover, the pension funds are put in a retirement account where they grow at a tax-deferred rate. Thus, there will be no due tax on the funds while they are still in the retirement account.

Choosing Between Monthly Annuity And Lump Sum

The choices of pension payment come about in the defined benefit plan. You can choose if you want a lump-sum distribution or a periodic payment for a lifetime. The periodic payment is usually monthly. Some pension plans do both periodic payments and lump sums. There are several factors to consider when selecting between a lump sum and a monthly annuity.

1. Monthly Annuity

Here the pension payments are offered as an option of a single life annuity for the employee retiring their whole life or a joint and survivor annuity for the employee retiring and their spouse. The spouse pays a lesser amount periodically, but the payment won’t stop until the surviving spouse dies.

For the people who choose to go with a single-life annuity, the payout stops as soon as the retiree dies. However, the surviving spouse will receive a tax-free large death benefit. This payout can be invested.

2. Lump-Sum

A lump sum protects you from the potential risk of your pension fund breaking. Also, you get the chance to invest your money to keep it working for you and even maybe earn a better interest rate while at it. By the time you die, and there is still money left from the pension plan, you can pass it down to your generation as your estate. However, with a lump sum, you do not enjoy the guaranteed lifetime income, and it will entirely depend on you to make money last.

If your pension plan is with an employer from a public sector, then the lump-sum distribution is equal to the employee’s contributions. Whereas for people employed in the private sector, the lump sum is the current value of the annuity.

What Yields More Money Between Annuity And Lump Sum

Simple calculations combined with a few assumptions can help determine which option produces the highest cash payout. To do this, you need an approximate value of the current annuity payments to figure out the projected interest rates for the monthly annuity payments.

Deciding Factors For Pension Maximization Analysis

There are basic factors that should be taken into consideration for any maximum analysis of pension funds. The variables are as follows:

  • Your risk tolerance
  • Your age
  • Estate planning considerations
  • The estimated return for the lump sum investment
  • Inflation protection
  • Your current financial situation
  • Your current health status and approximated longevity

Difference Between Defined Benefit Plan And Defined Contribution Plan

In a defined benefit plan, there is a guarantee of an employee receiving monthly payments when they retire for a lifetime. Some employees usually opt for a lump sum payment.

At the same time, in a defined contribution plan, the employer and employee make regular contributions to the pension funds account over the years. After retiring, the retired takes control of the pension fund account, and the employer no longer has any responsibilities.

The Time It Takes To Be Vested On A Pension Plan

Vesting is sometimes immediate, but it mostly takes about a year to start kicking in partially. When you contribute to the pension funds, as soon as you retire, they are yours. However, if the employer or company kicks in the funds, it will only be yours after you are fully vested.

Final Thoughts

While a pension plan will need contributions from the employer, it will also require additional contributions from the employee. It is important to know that leaving your job before retirement may affect the eligibility for a pension plan, especially the defined benefit plan