Understanding Retirement Plans

A pension plan is a means for providing income when you reach retirement age and will no longer be working. If you work for someone else, you may be eligible to participate in an employer-sponsored retirement plan. If you are self-employed, it will be your responsibility to set up and administer your own retirement plan.

For many employer-sponsored plans, eligibility is usually based on having attained age 21 and the completion of one year of service with the company. If your company is a corporation and offers a retirement plan benefit, it will be one of two basic types: either a defined benefit plan or a defined contribution plan.

A defined benefit plan provides the traditional pension. At retirement age, the company will pay you a fixed, lifetime income. The amount generally depends on your highest attained salary and the length of your employment. Defined benefit plans are typically financed entirely by the employer. You, the employee, generally pay nothing into this type of plan. The company assumes responsibility for ensuring that money is available to fund your benefit when you are ready to retire.

By comparison, a defined contribution plan does not promise a fixed lifetime pension. Instead, it requires that “contributions” (yours, the company’s, or some combination of both) will be made to a retirement account in your name. For example, a 401(k) plan is a defined contribution plan in which you (the employee) contribute a percentage of your salary (on a pre-tax basis) and the company, at its discretion, may make a matching contribution. The company assumes no responsibility for the size of the ultimate account. The size of your account depends on how much was contributed each year and how the money was managed.

Whose Money Is It?

Vesting denotes an employee’s entitlement to the funds in a plan. Generally, vesting is based on years of service with an employer, and with a few minor exceptions, the vesting rules are identical for defined benefit and defined contribution plans.

In a defined contribution plan, all employee contributions, and earnings on such contributions, are 100% vested from the start of participation in the plan. On the other hand, vesting for employer contributions usually takes place over a period of years. Should you leave your place of employment prior to retirement, you generally would be permitted to roll over the entire amount vested to date to another employer plan or to an Individual Retirement Account (IRA). If allowed by your plan, you may leave your vested amount in the plan (to be drawn upon at retirement).

In contrast, with a defined benefit plan, the commencement of your benefits is determined by the terms of the plan. Although you accrue a vested benefit over working years, the plan could specify that benefits will not commence until a participant attains normal retirement age (no later than the later of age 65 or the fifth anniversary of the date when plan participation commenced).

Many defined benefit plans also permit “early” retirement, although an early retirement benefit may be actuarially reduced because you (the participant) are expected to receive benefits over a longer period of time than would be the case with commencing benefits at normal retirement age. If you leave the company before normal retirement age, you could elect to receive an early retirement benefit if the age and service requirements (for early retirement) of the plan have been satisfied.

In some defined benefit plans, a former employee will have his or her retirement benefit frozen. In that case, while the former employee generally cannot roll over pension benefits from one employer’s defined benefit plan to another employer’s defined benefit plan, distribution of the employee’s benefit will commence upon reaching normal retirement age. If you have a frozen pension with a previous employer, find out how your retirement benefit will be calculated.

While neither plan is inherently better than the other, there has been a shift away from defined benefit plans toward defined contribution plans. Since the risks and potential rewards differ between the two basic types, it would be in your best interest to fully understand the plan that is available to you.         

 

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