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.
An alternative option for Marvin's company is to transition to a defined contribution plan, which is a retirement plan that requires an employer to make specific contributions to the retirement savings fund established by an employee under the plan. The most common defined contribution plan is a 401(k) plan, which is named after the section of the tax code that permits the creation of the plan. ERISA regulates these plans as well. Let's look at how they work.
Marvin's friend, Lisa, works for a company that offers a 401(k) plan. Under a 401(k) plan, Lisa has an individual retirement account. She's permitted to make contributions to the account, which are taxed deferred. This means she pays taxes after she withdraws the money from the account during retirement.
Her employer is also permitted to make matching contributions to the employee's account. It may also contribute additional funds to the account as part of profit-sharing. Sometimes employers will require a minimum time of service before the employer contributions are not forfeited upon leaving the company.
When the employer's contributions cannot be taken away from the employee, they are known as being vested with the employee. An additional feature of the plan allows Nancy to borrow against her retirement savings in certain circumstances. 401(k) plans are also portable. Nancy can transfer, or rollover, her funds into another qualified retirement account without any penalty if she changes jobs.
Unlike defined benefit plans, defined contribution plans do not guarantee a specific amount at retirement - the value of retirement funds will depend upon how successful the savings were invested. Nancy's company only promises to make contributions to an employee's retirement fund, and these funds are invested into financial markets. Her employer does not guarantee how much money will be available at retirement for Nancy. If the market tanks just before Nancy's retirement, funds available for her retirement may be severely diminished.
You can break employer-sponsored retirement plans into defined benefit plans and defined contribution plans. Traditional pensions are defined benefit plans where an employer guarantees a payment based upon a formula from the time of employment until the death of the employee. Surviving spouses are usually entitled to a reduced benefit.
A 401(k) plan is an example of a defined contribution plan where an employer does not guarantee any payment of benefits upon retirement but rather contributes a set amount of money to an employee's retirement account each year. Money available for retirement is based upon the market value of the funds at retirement. Any contributions made to it are not taxable until withdrawn at retirement. Employees can borrow from their 401(k) account in certain circumstances, and 401(k)s are portable.
Review this video lesson as you build your ability to:
- Differentiate between defined benefit plans and defined contribution plans
- Provide examples of each type of plan
- Display knowledge of the ways in which monies can be collected from cash payment plans, pensions and 401(k) plans