Pension Guide

A pension is a fixed amount of money that is paid regularly to a person, or retiree, typically following retirement from a job or service. The term “retirement plan” refers to pension that is allocated to an individual upon retirement, based upon legal contracts. Pension or retirement plans are established by the government, employers, insurance companies, and trade unions. Individuals receive pension or retirement benefits in regularly scheduled installments once they have retired.

Employment Retirement Income Security Act (ERISA)

The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that outlines minimum standards for most voluntarily established pension and health plans in private industry in order to provide protection for individuals in these plans. ERISA mandates pension plans to provide participants with important information regarding their individual plan features and funding, such as setting minimum standards for participation, establishing benefit accrual, offering fiduciary responsibilities for those who manage plan assets, and requiring all plans to include grievance and appeals processes. In addition, if a benefit plan is terminated, ERISA guarantees payment of other benefits through the federally sponsored corporation, known as the Pension Benefit Guaranty Corporation (PBGC).

Types of Pension Plans

 Defined Benefit Plan

A defined benefit plan offers a specified monthly benefit at retirement. Typically, the plan states this benefit as an exact dollar amount, such as $100 per month at retirement. In addition, defined benefit plans may calculate a benefit through a particular formula that considers factors as salary and service. The benefits in traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the PBGC.

Defined Contribution Plan

A defined contribution plan differs from that a defined benefit plan, in that it does not guarantee or promise a specific amount of benefits upon retirement. In these plans, usually both employer and employee contribute to the employee’s individual account at a set or fixed rate, such as five percent of earnings annually. After retirement, the employee will receive the balance in their account, which is based upon contributions and investments. The overall value of accounts under defined contribution plans fluctuates due to the changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.

Simplified Employee Pension Plans

A Simplified Employee Plan (SEP) grants employees the right to make contributions on a tax-favored basis to individual retirement accounts (IRAs) owned by the employees. Under a SEP, an employee must set up an IRA to accept the employer’s contributions. Although employers may no longer set up Salary Reduction SEPs, employers are permitted to establish SIMPLE IRA plans with salary reduction contributions.

Current Issues

According to the National Center for Policy Analysis, neither the public nor the private sector is ready for the 78 million baby boomers who will be retiring over the next 20 years. The financial crisis, recession, and the economy’s slow recovery and low interest rates have all contributed to depleted pension funds. Currently, states and businesses have been under-cutting the costs of pension plans in order to push the financial onus upon the federal government. The unfunded liability of Social Security and Medicare combined exceeds $107 trillion, which is nearly 6.5 times the size of the United States economy. According to Joshua Rauh, a finance professor at Northwestern University, public pensions may be underfunded by $4.4 trillion, up from $3.1 trillion in 2009. Furthermore, Bloomberg Rankings data indicate that states are also falling behind on retiree health care: of the $627 billion they are projected to owe, nearly 96 percent is not financed, an increase from 95 percent in 2009.

If these pressing concerns are not addressed, cities, counties and states will have to dip into tax collections to pay for pensions, cutting into essential funding for public works, police and fire departments and schools.

Reform

Since 2009, 43 states have enacted a variety of retirement reforms and measures, according to the National Conference of State Legislatures. These reforms include increasing employee contributions, adding to the number of years of service before benefits kick in, lengthening the final years of salaries on which payouts are calculated, and extending the retirement age to 67in order to keep up with advances in life expectancy, which now averages more than 78 years.

One more promising measure of reform is the hybrid pension plan, which encourages employees to save more independently. Hybrid plans combine a less-generous traditional pension with a 401(k)-style plan. Hybrids gradually move public employers away from traditional pensions, which cost state and local governments about $3 per hour worked.

Indiana is one state with a long history of implementing hybrid plans. Since 2005, states such as Alaska, Georgia, Michigan and Utah have also adopted hybrid plans for new employees. Currently, Rhode Island is the only state that has a hybrid requiring existing and newly hired workers to participate in the 401(k)-style plan. Employees must contribute up to five percent of their earnings (depending on salary), or nine percent if they are among the one-fourth of government workers nationally who do not contribute to Social Security. States such as California, Arizona, Kansas and Massachusetts are currently studying and considering implementing hybrid plans in the near future.

Additional Resources:

Pension Plans

Types of Retirement Plans

What You Should Know About Your Retirement Plan

The Wall Street Journal: Smart Money

Evaluating Your Retirement Options

Pension Performance Evaluation

Employee Benefit Research Program

Evaluation Retirement Plan Advisors

Your Fiduciary Role in Evaluation Your Retirement Plan

Pension Fund Performance

Organizations

United States Department of Labor

Pension Benefit Guaranty Corporation

Employee Benefit Research Institute

National Institute on Retirement Security

Retirement Planning

Taking the Mystery Out of Retirement Planning

Top Ten Ways to Prepare for Retirement

American Savings Education Council

CNN Money