Retirement Compensation Systems: 401(k) and Pensions

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  • 0:02 Types of Retirement Benefits
  • 1:05 Pensions & Cash Payment Plans
  • 4:04 401(k) Plans
  • 6:05 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley

Shawn has a masters of public administration, JD, and a BA in political science.

One of the most valuable benefits an employer may offer to employees are employer-sponsored retirement plans. In this lesson, you'll learn about two common retirement benefits: 401(k) plans and traditional pensions. A short quiz follows.

Types of Retirement Benefits

Marvin is an HR specialist that works for a large manufacturing company. He specializes in benefits administration. His company is in the middle of restructuring, and Marvin has been tasked with reviewing the company's current retirement benefits offered to employees and to determine if changes to the current retirement benefits are advisable. As Marvin knows, there are two general categories of retirement plans: defined benefit plans and defined contribution plans.

Defined benefit plans provide an employee with a set amount of retirement benefit when the employee retires, while defined contribution plans involves an employer making specific contributions to the retirement savings fund established by an employee under the plan each year. You can think of a defined benefit plan as being a plan that defines the exact retirement benefit an employee will receive at retirement and a defined contribution plan being a plan that defines exactly what the employer will contribute to an employee's retirement. Let's take a closer look at each type of plan.

Pensions & Cash Payment Plans

Marvin's company currently has a defined benefit pension plan. Bob is an employee that is about to retire from the company with a pension. His traditional pension benefit is based upon a formula, consisting of his years of service and his average salary during his final years of work. When he retires, he will receive pension payments until death. If Bob's wife, Beth, survives him, she will receive a reduced benefit.

One of the most important aspects of the company's plan, like any defined benefit plan, is that it constitutes a promise to employees like Bob that the company will pay a pension based upon the formula upon retirement. This payment is not optional. The company cannot decide to stiff Bob on its pension obligations. Of course, companies have defaulted on their pension obligations.

An alternative defined benefit plan is a cash balance plan. According to the U.S. Department of Labor, a cash balance plan 'is a defined benefit plan that defines the benefit in terms that are characteristic of a defined contribution plan.'

Fred is a friend of Bob's but works at a different company. Fred is retiring too, but he is retiring with a cash balance payment plan. While Bob's retirement benefits under his traditional defined benefit pension are defined as a series of payments made upon his retirement until his death, or the death of his spouse, Fred's guaranteed benefit is defined as a stated account balance.

Upon retirement, Fred is entitled to a guaranteed payment based upon the account balance. If Fred's stated balance is $350,000 upon retirement, his pension payments will be based upon that number. Some plans even allow people, like Fred, to take a lump sum payment equal to the account balance. Lump sums can usually be rolled over into another qualified retirement account.

It is important to keep in mind, however, that the employer is still responsible for making these guaranteed payments even if the actual value of the account goes down. If the money invested in retirement payments takes a beating in the market, for example, the company still has to pay Fred his retirement benefits based on the account balance because gains or losses from investment don't affect the employer's obligation. This is why account balances like Fred's are often referred to as hypothetical account balances because they really don't represent actual contributions or actual gains or losses. It's just a way to define, or make sense, of the benefit.

Bob and Fred's pensions are protected by federal law. Defined benefit pensions plans are regulated by the Employee Retirement Income Security Act of 1974 (ERISA). Additionally, the company's retirees are protected by the Pension Benefit Guaranty Corporation (PBGC). It guarantees the payment of retirement benefits of qualified defined benefit plans should the company benefit plan default on its obligation due to lack of funding.

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