Pension
From Wikipedia, the free encyclopedia.
A pension (also known as superannuation) is a retirement plan intended to provide a person with a secure income for life. Although a lottery may provide a pension, the common use of the term is to describe the payments a person receives upon retirement.
Pensions have traditionally been payments made in the form of a guaranteed annuity to a retired or disabled employee, or to a deceased employee's spouse, children or other beneficiaries. A pension created by an employer for the benefit of an employee is commonly referred to as an occupational or employer pension. Labor unions, the government, or other organizations may also sponsor pension provision.
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Types of pensions
A "pension plan" or "retirement plan" is an arrangement by which an employer (for example, a corporation, labor union, government agency) provides income to its employees after retirement. Pension plans are a form of "deferred compensation" and became popular in the United States during World War II, when wage freezes prohibited outright increases in workers' pay.
Pension plans can be divided into two broad types: Defined Benefit and Defined Contribution plans. The defined benefit plan had been the most popular and common type of pension plan in the United States through the 1980s; since that time, defined contribution plans have become the more common type of retirement plan in the United States and many other western countries.
Some plan designs combine characteristics of defined benefit and defined contribution types, and are often known as "hybrid" plans. Such plan designs have become increasingly popular in the US since the 1990s. Examples include Cash Balance and Pension Equity plans.
Defined Benefit Plans
The defined benefit plan (as its name implies) defines a benefit for an employee upon that employee's retirement. The benefit in a defined benefit pension plan is determined by a formula, which can incorporate the employee's pay, years of employment, age at retirement, and other factors. A simple example is a flat dollar plan design that provides $100 per month for every year an employee works for a company; with 30 years of employment, that participant would receive $3,000 per month payable for their lifetime. Typical plans in the United States are final average plans where the average salary over the last three or five years of an employees' career determines the pension; in the United Kingdom, benefits are often indexed for inflation. Formulas can also integrate with public Social security plan provisions and provide incentives for early retirement (or continued work).
Traditional defined benefit plan designs tend to exhibit an S-shaped accrual pattern of benefits, where the present value of benefits grows quite slowly early in an employees' career and accelerates significantly in mid-career. Defined benefit pensions are usually not portable - accrued benefits in defined benefit plans are typically payable only at retirement - even when the employee has a vested interest in the benefit. On the other hand, defined benefit plans typically pay their benefits as an annuity, so retirees do not bear the risk of outliving their retirement income.
The United States Social Security system is an example of a defined benefit pension arrangements, albeit one that is constructed differently than a pension offered by a private employer.
The "cost" of a defined benefit plan is not easily calculated, and requires an actuary or actuarial software. However, even with the best of tools, the cost of a defined benefit plan will always be a estimate based on economic and financial assumptions. These assumptions include the average retirement age and life span of the employees, the returns earned by the pension plan's investments and the cost of insurance from the Pension Benefit Guarantee Corporation which is predicted to increase in the near future. So, for this arrangement, the benefit is known but the contribution is unknown even when calculated by a professional.
In the US, the Internal Revenue Code (IRC) defines a defined benefit plan [Internal Revenue Code Section 414(j)]. The IRC's definition for the defined-contribution plan is an individual account plan -- meaning that employees/participants own an account. Despite the fact that the participant typically has control over investment decisions, the plan sponsor retains a significant degree of fiduciary responsibility over investment of plan assets, including the selection of investment options and administrative providers.
Defined Contribution Plans
In a defined contribution plan, the contribution is defined, but the benefit is unknown. A typical defined contribution arrangement is one under which contributions are made (by the employer, the employee, or both) into an account which grows via investment. At retirement, the employee has an account that can be used to purchase an annuity, or can have amounts withdrawn as the financial need for the employee arises.
Defined contribution pensions, once vested, are generally portable.
In a defined contribution plan, investment risk and investment rewards are assumed by each individual/employee/retiree and not by the sponsor/employer. In addition, participants do not typically purchase annuities with their savings upon retirement, and bear the risk of outliving their assets.
The "cost" of a defined contribution plan is readily calculated. But, the benefit from a defined contribution plan depends upon the account balance at the time an employee is looking to use the assets. So, for this arrangement, the contribution is known but the benefit is unknown (until calculated).
Hybrid and Cash Balance Plans
Hybrid plan designs combine the features of defined benefit and defined contribution designs. In general, they are usually treated as defined benefit plans for tax, accounting and regulatory purposes. As with defined benefit plans, investment risk in hybrid designs is largely borne by the plan sponsor. As with defined contribution designs, plan benefits are expressed in the terms of a notional account balance, and are usually paid as cash balances upon termination of employment. These features make them more portable than traditional defined benefit plans and perhaps more attractive to a more highly mobile workforce. A typical hybrid design is the Cash Balance Plan, where the employee's notional account balance grows by some defined rate of interest and annual employer contribution.
In the US, plan conversions from traditional to hybrid plan designs have been controversial, notably at IBM in the late 1990s. Upon conversion, some plan sponsors retrospectively calculated employee account balances -- if the employee's actual vested benefit under the old design was less than the account balance, the employee entered a period of wear away where he or she accrued no new benefits. Hybrid designs also typically eliminated the generous early retirement provisions in traditional pensions.
As a result, critics of cash balance plans have seen the new designs as discriminatory against older workers. On the other hand, the new designs may better meet the needs of a modern workforce and actually encourage older workers to remain at work, since benefit accruals continue at a constant pace as long as an employee remains on the job. Court cases have not resolved these problems, and currently there is legislation before the United States Congress to clarify the legal status of cash balance and other hybrid designs.
Financing
There are various ways in which a pension may be financed.
In a funded defined contribution pension, contributions are paid into a fund during an individual's working life. The fund will be invested in assets, such as stocks, bonds and property, and grow in line with the return on these assets. (An unfunded defined contribution pension is an oxymoron.)
In an unfunded defined benefit pension, no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid. Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly from current workers' contributions and taxes. This method of financing is known as Pay-as-you-go. It has been suggested that this model bears a disturbing resemblance to a Ponzi scheme.
In a funded defined benefit arrangement, an actuary calculates the contributions that the plan sponsor must make to ensure that the pension fund will meet future payment obligations. This means that in a defined benefit pension, investment risk and investment rewards are typically assumed by the sponsor/employer and not by the individual. If a plan is not well-funded, the plan sponsor may not have the financial resources to continue funding the plan. In the United States, private employers must pay an insurance-type premium to the Pension Benefit Guaranty Corporation, a government agency whose role is to encourage the continuation and maintenance of voluntary private pension plans, provide timely and uninterrupted payment of pension benefits.
A growing challenge for many nations is population ageing. As birth rates drop and life expectancy increases and ever larger portion of the population is elderly. This leaves fewer workers for each retired person. In almost all developed countries this means that the pension system will eventually go broke unless reformed. The three exceptions are Australia, Canada, and the United Kingdom where the pension system will be solvent for the foreseeable future. In Canada, for instance, the annual payments were increased by some 70% in 1998 to achieve this. These three nations also have an advantage from their relative openness to immigration.
Pension systems in various countries
- Canada Pension Plan
- Indian pension system
- Social security (Sweden)
- Retirement plans in the United States
- Social security (United States)
- Sipps Pensions (United Kingdom)
