What Is a Pension? Types, Benefits and More What is a pension, how does a pension work, and what are the different pension plans? Entrepreneur is here to answer your questions.
By Dan Bova
As a member of the workforce who is conscientious about the future, you've likely heard about pensions, especially during the hiring or onboarding process. Government jobs, in particular, offer pension plans as part of their benefits package.
Like any other benefit, there are different types, intricacies and critical details regarding pensions. Read on to learn everything you need to know about pensions.
What is a pension?
A pension is an employee benefit plan created and supported by an employer and either supplies retirement income or defers income until employment changes.
Pensions are meant to provide monetary support to employees after they retire so they can maintain a comfortable life even after working for that company.
The benefit plan is a way to contribute money throughout your employment to set yourself up for future success and comfort.
The history of pensions
The United States' first pension plan came in 1875 through the American Express Company.
At its inception, employers funded pension plans and paid employees a specific benefit each month. After American Express created its pension plan, other banks, utility and manufacturing companies followed suit.
Even though pension plans became more common over the next century, they did not carry any protection behind them. In 1963, Studebaker, an automobile company that employed over 4,000 workers, terminated its pension benefits.
This was not the only incident of large companies leaving workers out to dry — most companies that went out of business could not follow through on pension benefits, leaving employees with nowhere to turn.
After incidents like this continued, legislators decided it was time to create change and introduced pension reform legislation to protect the benefits and futures of the American workforce.
In 1974, the Employee Retirement Income Security Act (ERISA) went into effect. This new federal law created a pension insurance program, which protected employee benefits and private pension plans.
The ERISA sets minimum standards for retirement plans and includes information like:
- Plan features and funding
- Minimum standards for participation and vesting
- Minimum standards for benefit accrual and funding
- Fiduciary requirements of plan managers
- How to file appeals or grievances
- Guarantee of payment through PBGC, even if the defined benefit plan is terminated
It is vital to note that ERISA focuses on the private sector and does not cover plans for:
- Government entities
- Churches
- Plans solely in compliance with worker's compensation, unemployment, or disability
- Plans outside the U.S.
Because of the new act, ERISA triggered the inception of the Pension Benefit Guaranty Corporation (PBGC), which still exists today. It is a task force that operates under the Department of Labor to carry out the new laws of private pension protection under ERISA.
Notable numbers for the PBGC include the following:
- 33 million retirees, workers, and their families have protected private-sectorpension plans
- Approximately 900,000 retirees with 4,600 failed company retirement plans still received pensions
- More than 620,000 are set to receive benefits upon retirement
Related: How to Maximize Your Social Security
Types of pension plans
The ERISA includes two different types of benefit plans. It is essential to understand the complexities when deciding which is suitable for you.
Defined benefit plan
A defined benefit plan defines the specific monthly payment a person receives once retirement begins. There are two ways a person can set up their plan to determine their particular monthly benefit.
Annuity
An annuity is the exact dollar amount the employee receives each month for the rest of their life once their retirement begins.
Generally, only the former employee can collect annuities, though the employee can also include their spouse in their plan so the spouse can also collect the retirement money.
One of the benefits of annuities is that they are automatically portioned out for the employee, meaning the employee can't spend their benefit all in one place, mimicking the cycle of a regular paycheck.
Related: Annuities: Types and Examples
Lump sum
A lump sum is a calculated benefit amount determined by a formula that factors salary and service. Employees who collect their retirement benefits as a lump sum receive all their contributions at once rather than being portioned out on a monthly schedule.
While the government protects pension plans, there is always a minimal chance that a plan could collapse. One benefit of a lump sum is that it is guaranteed income that employees can use for whatever they want or need.
Related: Received a Lump Sum of Money? Here's What You Might Want to Do Next
Defined contribution plan
With a defined contribution plan, the employee, the employer or both contribute to the employee's savings plan. The contribution will often be a set rate, like a percentage of the employee's annual earnings.
Usually, the employee contributes a percentage of their wages to store away for the future. However, some companies offer contribution matches or percentages, which is something to be aware of when taking a job with any company.
The employee will have access to the retirement savings amount accumulated over the number of years of service. Because the defined contribution plan is based on a percentage of investment, the amount may fluctuate based on investment value.
Types of defined contribution plans include:
- 401(k) plans
- 403(b) plans
- Employee stock ownership plans
- Profit-sharing plans
- Simplified Employee Pension Plan (SEP)
Read on for a more in-depth rundown of these defined contribution plans.
Related: Best Retirement Plans – Broken Down By Rankings
Types of 401(k) plans and everything else you need to know
Because 401(k) falls under the defined contribution plan category, these plans allow employees to contribute a portion of their pre-tax wages to their retirement accounts.
Specific features of 401(k) plans include:
- Deferrals are not included in a worker's taxable income (unless they are designated as Roth).
- Employers can contribute to employee plans.
- Earnings and distributions can be included as a part of taxable income upon retirement (unless they are designated as Roth).
- 100 percent vested elective deferrals.
401(k) plans are defined distribution plans, but there are even subtypes of the 401(k) as well.
Traditional 401(k) plan
A traditional pension plan makes it possible for eligible employees to participate in a plan to use payroll deductions to contribute to their plan. Employers of any size can implement this type of plan. It can also be combined with other retirement plans.
Employees may make these deferrals independently, or their company might match the deductions. Many 401(k) plans require employer contributions to remain nonforfeitable after a certain amount of time, ensuring the employee's financial security.
A few other rules of the traditional 401(k) include:
- Contributions must meet nondiscrimination requirements.
- Employers must perform annual tests (Actual Deferral Percentage and Actual Contribution Percentage) to ensure deferrals do not favor only employees with high.
Safe harbor 401(k) plan
Similar to the traditional plan, employers of any size can implement this type of plan. It can also be combined with other retirement plans.
However, there are two critical differences between a safe harbor plan and a regular plan.
- Employer contributions must be fully vested when made.
- Plans are not required to undergo the same ADP and ACP testing.
Another feature of the safe harbor plan is that employees are meant to stay informed with notice requirements about:
- Employee rights
- Employee obligations
- Content: The method used, the employee election process, and other involved plans and information
- Timing: At least thirty days' notice of details before each new plan year
SIMPLE 401(k) plan
The SIMPLE plan is targeted toward small businesses. It was meant to provide more options and cost-efficient ways for small businesses to serve their employees.
Features of the SIMPLE 401(k) plan include:
- Plans are not required to undergo the same ADP and ACP testing
- Employer contributions must be fully vested when made
- Must be a business with less than 100 or fewer employees who earned at least $5,000 in wages in the prior calendar year
- Employees are limited in this plan, as they cannot receive contributions or accruals with other plans
Limitations of 401(k) plans
If you are considering a 401(k) plan for your future, there are a few things to note about its limitations.
- Annual contribution limits: Elective salary deferrals and a limit on contributions
- Deferral limits for traditional and safe harbor: $22,500 in 2023 — determined by cost-of-living
- Deferral limits for SIMPLE:$15,500 in 2023— determined by cost-of-living
- Elective deferrals are subject to plan-by-plan details
Related: Everything You Know About Your 401(k) is Wrong. Here's Why and What You Should Do About It
Starting up a 401(k)
As employers set up a 401(k) plan for their company, there are a few requirements they'll need to consider.
Whether you are an employer doing research or an employee looking to know more about the behind-the-scenes process, consider all 401(k) plans must have the prerequisites.
- Type of plan document: Individually designed, Master and Prototype or Volume Submitter
- The effective date of the plan: Must be made effective after the first day of the employer's tax year
- A request of determination letter (not legally required):IRS review and approval of plan document
- Distribution of information: Employees are notified about who is eligible, participation details, plan updates
- Trust: Must be established, hold and invest in plan assets, maintain liability
- Contributions to trust: Employer contributes elective deferral amount no later than the fifteenth day of the month
- Employee elective deferrals (automatic enrollment possible): Employees inform the employer of the wage deferral amount and start date
403(b) plans
A 403(b) plan is one offered to open to some regions of the public sector, including public school employees and some employees who work for 501(c)(3) tax-exempt organizations.
This plan can also be referred to as a tax-sheltered annuity or a TSA plan. With a 403(b) plan, employees and employers can contribute to their investment accounts by deferring a portion of their income.
Employers who can offer 403(b) plans are:
- Public schools, colleges and universities
- Churches
- Charitable organizations that are tax-exempt under Section 501(c)(3) of the Internal Revenue Code
- Cooperative hospital service organizations
A 403(b) plan offers flexibility regarding contributions, loans and hardship distributions. On the other hand, employers can limit their employees' investment options, and the plan is also subject to high administrative costs.
Employee stock ownership plans (ESOP)
Employee stock ownership plans are defined contribution plans through which the investments are predominantly in employer stock. When creating an ESOP, a company must set up a trust fund and contribute new shares or cash into its stock to purchase existing shares.
Employees can obtain stock by:
- Buying stock directly
- Receiving stock as a bonus
- Receiving stock options
- Getting stock through a profit-sharing plan
ESOPs are among the most common types of employee ownership plans, with over 14.2 million participants. Employees may be attracted to this type of plan because they can acquire more shares as they move up to higher positions within the company.
This is another way to contribute to an employee retirement plan because the longer an employee stays with that company, the larger their payout may be upon retirement.
ESOPs are most commonly used for:
- Buying the shares of a departing owner
- Borrowing money at a lower after-tax cost
- Creating more benefits for employees
Tax benefits associated with ESOPs are:
- Tax-deductible stock contributions
- Deductible cash contributions
- Tax-deductible contributions used to repay loan withdrawals by ESOP to buy company shares
- Tax deferrals for sellers in C corporation
- Ownership percentage held by ESOP of S corporations not subject to federal income tax (and many state taxes)
- Tax-deductible dividends
- No tax for employee contributions
Profit-sharing plans
Profit-sharing plans are employer-only, discretionary distributions. With this plan, "discretionary" means that there is no set amount employers are required to contribute. It allows employers to choose whether to contribute yearly to employee retirement.
However, if an employer chooses to contribute, they must do so with a set formula to determine each participant's allocation. Profit-sharing plans offer flexibility, as they allow for other retirement plans and work for businesses of any size.
Simplified employee pension plan (SEP)
A SEP is an option that many employers like because there are no filing requirements, start-up costs or operating costs.
In addition, SEPs allow for employer contributions of up to 25% of each employee's pay. With this percentage available for contributions, employees and employers have the potential to collect a significant amount of income upon retirement.
SEPs are open to businesses of all sizes and are simple to establish with an individually designed plan, Form 5305-SEP or a SEP template. Only the employer contributes to SEPs, and employees are wholly vested in all SEP money.
Related: Simplified Employee Pension Plan (SEP) - Entrepreneur Small Business Encyclopedia
Cash balance plan
A cash balance pension plan is a defined benefit plan in which a cash balance is a guaranteed benefit of a stated account balance.
Each year a participating employee receives a pay credit, a percentage of compensation from the employer, and an interest credit, a fixed or variable rate linked to a specific index.
Cash balance pension plans assume more risk on the employer than the employee because investment risks are carried by the employer exclusively. Regarding collecting a cash balance plan on retirement, the participant can receive their pension with an annuity or lump sum.
Once an employee collects a lump sum, it is there to spend or invest as they want, including rolling the pension money into another IRA or retirement plan that accepts rollovers.
Related: Want to Lower Your Taxes? Make the Most of Retirement Planning Tools Like 401(k)s and IRAs.
What information should retirement plans include?
There are many retirement plans, each with unique benefits and stipulations. However, one consistent requirement that all plans have is that employers must provide employees with a Summary Plan Description (SPD). Summary Plan Descriptions provide employees with information about plan details, requirements, and notices.
Other key plan information employers must provide includes:
- Automatic enrollment notice
- Individual retirement account benefit statements
- Annual funding notice
- Plan and investment information
- Summary of material modifications
- Summary annual report
- Notice of significant reduction in future benefit accruals
- Blackout notice
- Notice to participants of the underfunded plan
- Notice of critical or endangered status
Related: Do You Need a Financial Advisor Before the End of the Year? Here's How to Know for Sure
Frequently asked questions about pensions
When researching the right pension plan for you, there is undoubtedly a volume of information to sift through. The frequently asked questions below can help build some basic knowledge before you narrow down your search.
When can employees begin to collect retirement benefits?
Federal law requires payment of retirement benefits to begin the latest of:
- Reaching age 65 or the age your plan considers to be retirement age
- 10 years of service
- Terminating employment
As with all legal documents, make sure you read the fine print of your pension plan. There are certain intricacies with timing, taxes and more that you must follow to collect full benefits.
What is the latest time employees can collect benefits?
Generally: 72. Federal law requires that people start collecting benefits at 72 years old; however, some types of retirement plans require a sooner start date.
How are pension benefits paid?
Pension payment benefits depend on the type of pension plan you have and the type of payment you choose.
If you choose an annuity, you receive periodic payments for the rest of your life. If you choose a lump sum, you receive one large payment of all your benefit money at once.
Will pension benefits continue for the employee's spouse if they die?
It's up to you. Your surviving spouse automatically receives your benefits on a defined benefit pension plan or money purchase plan unless you choose otherwise. The amount your spouse receives might differ from yours, depending on the details of your plan.
With a defined contribution plan, your surviving spouse automatically receives your benefits even if you pass away before receiving them. You may select a different beneficiary, but your spouse must sign off on that decision.
Can employees borrow from their 401(k) plan accounts?
Yes. Again, this often depends on your 401(k) details, but it is generally possible to take loan money from your plan. Loans typically charge reasonable interest rates, are secured and are limited to the lesser of 50% of your account balance. You must repay the loan within five years.
If an employee leaves before retirement, can they take their retirement benefit with them?
With any defined benefit plan other than the cash balance plan, most plans require you to leave benefits unless otherwise eligible.
Some cash balance plans offer the option to transfer a portion of the account balance to another retirement fund. In a defined contribution plan, most employees can transfer the account balance to the pension plan with their next employer.
Related: Retirement Doesn't Have to Mean Golf Courses and Fishing — It Can Be Whatever You Want It to Be
Choosing the right pension plan for you
Pension plans are a way for people to work towards financial security as part of their employment. There are several different types of pension funds, and they all have their pros, cons and factors that make each the right one for different people.
When choosing your pension plan, read the fine print about contributions, timing, vesting and other vital details.
For more information on personal finance, retirement, and financial planning, visit Entrepreneur to help with your investment decisions.
