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Traditional Pension Plans

Do you receive an employer-paid pension? Count yourself lucky!

If you work or have worked for a corporation that offers a traditional pension plan, also called a defined-benefit plan, you have a great head start on preparing for retirement. This article reviews two types of pension plans: defined-benefit and defined-contribution.

Defined-Benefit Plans

The defined-benefit, or traditional pension benefit, is funded solely by your employer and is calculated based on a formula that uses your base compensation and your number of years of service. There are different methods of computing your benefit, depending upon your particular plan. For example, some plans may use your final annual compensation, while others may use an average of your salary for the past 3 to 5 years. The most important element to understand is that the longer you remain employed, the higher your defined benefit will be. Let's say your plan uses a formula of 1% of your base salary level of $65,000 for each of your 10 years of service. The formula would look like this:

Years of Service

Annual Pension Benefit

Percentage of Working Income

10

$6,500

10%

20

$13,000

20%

30

$19,500

30%

Vesting – When an employer contributes to a pension fund, vesting is the length of time the employee must work for the company before he owns the employer contributions. As of 2006, U.S. law specifies that you become fully vested on either a three-year cliff (100% after three years) or a six-year graded (20% for each year of service beginning with the second year of service) vesting schedule. Becoming fully vested means you are eligible to receive all of your pension when you retire. If you leave the company or retire before you are fully vested, you are still eligible to receive a percentage of your pension. Depending upon your plan, you may not be able to access your money until you reach retirement age. In that case, some plans allow you to transfer (roll over) your vested portion into another qualified retirement plan.

Since employers fund defined-benefit plans, it's important to monitor the financial condition of the company to make sure it has the financial ability to make payments in the future. Fortunately, there is a federal agency called the Pension Benefit Guaranty Corporation (PBGC) that oversees employer-paid pensions and provides for certain payment guarantees in the event a company is unable to make its payouts. Unfortunately, the PBGC has suffered serious losses leading to annual deficits in recent years.

Defined-Contribution Plans

A defined-contribution plan is one in which the employer contributes a certain sum toward your retirement. This type of plan can take the form of a 401(k), profit sharing, or stock ownership, and doesn't establish a specific pension amount. The returns from defined-contribution plans and the size of your retirement are market dependent, meaning that the eventual value of your pension is a direct result of the investment decisions that are made.

Defined-contribution plans are most commonly retirement accounts (such as 401(k) plans, Individual Retirement Accounts, or Keogh plans) to which both the employer and employee contribute. The funds in these accounts are usually invested in mutual funds, the stock market, or government bonds.

The Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code govern how pension plans are administered. For more information about ERISA, see the U.S. Department of Labor's Office of Compliance Assistance webpage at www.dol.gov/compliance.

Pension Protection Act of 2006

The Pension Protection Act of 2006 was passed in order to protect workers' employer-sponsored retirement investments and to encourage employees to take a greater responsibility for contributing to their retirement plans.

In an attempt to protect against underfunding, the new law requires that companies fully fund their defined benefit pension plans within seven years, beginning in 2008. In a fully funded pension plan, the funds currently available are enough to cover the retirement benefits promised to the workers participating in the plan. If employers do not meet the fully funded requirement, the pension plans will be labeled at-risk and be restricted in terms of benefit increases and distributions. Companies will also receive higher tax deductions for their contributions to pension plans.

Defined-benefit pension plans are becoming rare and may soon be history. The Pension Protection Act helps to shift the risk and responsibility for retirement savings onto workers. It does so by providing incentives to both employees and employers to establish and maintain defined-contribution plans. See the Special Summary of the Pension Protection Act of 2006 for some of these changes.

When It's Time to Retire

When you ultimately retire, you will be faced with making a choice on how to access your pension fund. You will generally be offered the following options:

  • Receive a lump-sum distribution. If you choose this option, you'll want to be very careful to reinvest your retirement funds cautiously. If you don't roll these funds into another tax-deferred investment, such as an Individual Retirement Account (IRA), your money will be fully taxable when you receive it.

  • Receive a "single-life" annuity or monthly payment for a fixed number of years. This option generally results in the highest monthly payment amount, but be wary because if you live longer than your pre-selected estimated life expectancy, you may end up without this portion of your retirement income in later years.

  • Take an annuity or monthly payment for the rest of your life. This option may produce a lower monthly payment than the single-life option, but you are assured of receiving it for life.

  • Take a "joint and survivor" annuity or monthly payment for the rest of your life with an option that guarantees your spouse a survivor benefit. Under this option, your monthly annuity is at its lowest, but if you have a spouse that is not eligible for retirement benefits, this will ensure that he or she continues to have an income if he or she survives you.

Be careful when choosing an annuity. Some annuity schemes (such as annuities invested in the stock market) are very risky and not a good idea for older people depending on that income. There are also annuity scams. See this USA Today article about annuity fraud.

There are many things you'll want to evaluate before choosing your distribution options. In addition to assessing your other retirement income sources, you may also want to consider your age, health, marital situation, tax situation, and projected living expenses. You may have a benefits administrator who can run several "what-if" scenarios to help you decide. Remember, though, whatever you choose, it's not generally reversible so plan carefully. For more information about pension plans, read the related articles in our Knowledge Center Library.

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