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Tom
July 21, 2014

What is a Pension Plan?

Today we’re taking you back to the old school. To a land of gold watches and working 30 years at the same firm. A time where a man’s word meant something.

A time of pension plans.

A pension plan is a tax-exempt retirement plan that is typically funded by the employer. Some plans do allow for employees to contribute funds as well. The contributed funds are pooled together and invested for the employee’s benefit.

Having a pension might mean your take-home pay is a little lower than it would be otherwise thanks to your employer contributing to a pension on your behalf. In the long run this works out to your benefit, but it is something to keep in mind.

At retirement the employee has two choices as to how to handle their pot of money in the pension pool. They can begin to tap the pension plan and it pays out a benefit to the employee or they can sell their pot of money to an insurance company in exchange for annuity.

This is significantly different from other retirement plans in two ways:

Employee Investment Control

With a 401k, IRA, or Roth IRA you control how the funds are invested. In most pension plans the control is left in the hands of the pension administrators. The company selects a financial company to manage and invest the funds on behalf of the plan. You can’t elect to put the funds in more aggressive or conservative investments nor in lower cost options. The money is invested for you, and what’s there in retirement is what you get.

Who Contributes Majority of Funds

With traditional retirement options you invest a majority of the funds. A generous employer might offer a 100% match on the first 6% of your salary you contribute, but that still means you are providing 94% of the contribution for your retirement.

With a non-qualified pension plan the employer is typically the one to provide a majority of the contribution. Even if you do have the option to contribute to a non-qualified pension, the contribution comes from post-tax dollars and is not deductible.

2 Types of Pension Plans

Here are the two types of pension plans:

Defined Benefit Pension Plan

How would you like to have a guaranteed amount at retirement? That’s the end result of a defined benefit pension plan. This pension plan is typically tied to years of service at the firm, salaries over those years, and perhaps a few other factors. It’s a math equation that results in a number that you will get when you get to retirement. (Your benefits department can walk you through your company's specific calculation.)

The retirement benefit is defined as a set (or calculable) amount. There’s no guessing as to what your retirement benefit will be with a defined benefit pension plan. The company contributes on your behalf each year and it is their responsibility to have the funds available to pay out to you based on the calculation the plan is based on.

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Defined Contribution Pension Plan

With this pension plan it isn’t the benefit (the monthly payout in retirement) that is defined but the contribution into the investment pool for your retirement. A company might define that it will contribute $200 every month into the pension on your behalf.

This guarantees the contribution not the final result. Your pension amount at retirement would fluctuate based on the performance of that investment pool. If the pool performed poorly your pension amount would be smaller than it could have been with outstanding performance.

Benefits of Having a Pension Plan

Pension plans are great if you can find an employer that still has one. Most employers that once had pension plans have phased them out over the years.

The best benefit with pensions comes from the Defined Benefit Pension plan. With this plan your pension amount in retirement isn’t based on the performance of an investment. Instead, a calculation based on the number of years of service, your salaries over those years, and some other factors spits out a number that equals what you get in retirement. That amount is guaranteed by the employer, not by the investment performance of the plan.

These plans offer an additional source of retirement income for you without having to put in any extra effort. Assuming the plan is run effectively – and that is a big assumption – you'll get an extra stream of income when you finally stop working.

Risks of Having a Pension Plan

Unfortunately not every pension plan is run effectively. In fact many of the big headlines in the personal finance industry from the last several years are about pension plans imploding or having benefits cut.

This is the ultimate downside of a pension: trusting it will be around when you retire.

You can take your other retirement options for granted and end up relying completely on a plan that may not be as strong as you think it is when you get to retirement. If you've put 100% of your retirement income future into the pension plan and benefits are cut, you have no safety net to help you out.

Two recent examples of pension cuts:

  • Detroit is going through the largest municipal bankruptcy in history. As part of the proceedings the pension plan of Detroit's workers – firefighters, city employees, and such – is at significant risk.
  • United Airlines defaulted on pension obligations in 2005. Many employees saw cuts in their monthly pension benefits.

Having a pension benefit is great, but as with any other retirement option it should never be your only source of retirement income. Putting all of your eggs into one basket is extremely risky.

What Happens If My Pension Plan Goes Under?

The likelihood that a plan would completely go under is unlikely. The more common risk is that the pension pool is underfunded. From an accounting standpoint pension plans are a liability to an organization instead of an asset. They are taking money out of income and putting it to another “entity” on behalf of the employees, so it is a liability.

During lean years the company is tempted to rob Peter to pay Paul, so they underfund that year's pension allotment and promise to make it up in the future. As you might imagine sometimes that “make up” amount never materializes and the underfunding continues for several years (or decades).

This can put the whole firm at risk because, again, the pension plan is an accounting liability. If the plan can't meet the pension payments a governmental agency called the Pension Benefit Guarantee Corporation steps in to cover the difference between what a pensioner is owed and what the plan can provide.

Think of the PBGC like the FDIC for bank accounts when a bank goes under – the FDIC steps in to guarantee the first $250,000 in assets you had at the bank. There are limits to what the PBGC can offer, but it definitely helps.

Pension Calculator

When Can I Receive Pension Benefits?

You have to wait until retirement age before you can tap your pension. For most plans this is 65 years of age. There may be a rule that allows you to start taking benefits 5 to 10 years earlier but at a reduced amount. (This is similar to tapping Social Security before your true retirement age.)

What Happens If I Leave My Company Before Retirement?

Most individuals entering the workforce now will have many jobs throughout their years leading up to retirement. So what happens when you leave a company that has a benefit plan before retirement?

The answer is… it depends. In some instances you will end up sacrificing whatever pension benefits you had built up because you didn't stay with the company long enough to vest into the plan. In other instances you will have vested, but you still can't touch the funds. You have to wait until retirement age and get back in touch with the plan administrators to claim your benefit. This is significantly different than a 401k plan where you can take the funds in the 401k and roll them over into a new 401k or Traditional IRA.

Two Methods to Tapping Your Pension

You can tap your pension in two ways:

Monthly Benefits

With the monthly benefit option – the most common choice – you get a monthly check from the pension plan. It's like getting a Social Security check every single month. You continue to get checks until you die. (This option is also known as a life annuity since you get payments for life.)

Lump Sum

This is the more risky but potentially more rewarding option. Instead of getting a monthly check the company gives you a lump sum payment. The money is then yours to invest in a manner that gives you the same level of monthly income that you would have received with the monthly payment option.

This is risky because:

  1. You may not manage the funds effectively enough to generate the same level of income security
  2. You may be tempted to spend a lot of money up-front because you are holding a large check in your hands.

The upside is:

  1. You don't have to rely on your company surviving or managing/funding the pension well until your death. You get to cash out now.
  2. You get control of the funds. If you can manage them correctly you can end up in a better financial position than you would have had with the monthly payment option.
  3. You can leave remaining funds to your heirs.

Final Note

If  you are a person that currently owns a pension plan, I would be very cautious in holding on to it because the dollar will collapse, it is just a matter of when. Your money will be completely worthless and your hard earned savings will be GONE. It is important that you begin doing your research to find other alternative investments to diversify your retirement plan. One way you can do this is with Gold. Watch this free video now.

About the author 

Tom

Tom is a former accountant turned entrepreneur. He is not a financial adviser but does tend to give a lot of financial advice to his friends and colleagues. He currently runs a small online venture and blogs about his research and experiences.

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