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Understanding Retirement and Pension Plans

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  • 0:05 Retirement Plans
  • 1:03 Pension Plans
  • 2:03 How Pension Plans Work
  • 4:07 401(k)
  • 5:42 How 401(k) Plans Work
  • 7:28 Lesson Summary
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Lesson Transcript
Instructor: Ashley Dugger

Ashley is an attorney. She has taught and written various introductory law courses.

Businesses use many different types of retirement plans for their employees. Two of the most common are pension plans and 401(k) plans. This lesson discusses these two kinds of retirement plans.

Retirement Plans

Different businesses use different types of retirement plans. Though all business retirement plans are designed to help employees save money for retirement, the different plans serve slightly different purposes. If you've worked a few different jobs for a few different types of companies, then you've likely encountered more than one type of retirement plan. The plans can seem like an alphabet soup. They include:

  • Individual Retirement Arrangement, or an IRA
  • Roth IRA
  • 401(k) Plan
  • 403(b) Plan
  • SIMPLE IRA Plan (Savings Incentive Match Plan for Employees)
  • SEP Plan (Simplified Employee Pension)
  • SARSEP Plan (Salary Reduction Simplified Employee Pension)
  • Profit-Sharing Plan
  • Defined Benefit Pension Plan
  • Defined Contribution Pension Plan
  • Employee Stock Ownership Plan (ESOP)
  • 457 Plan
  • 409A Nonqualified Deferred Compensation Plan

Pension Plans

Historically speaking, the most common type of retirement plan is the pension plan. This is simply an employer plan for setting aside money for an employee's retirement. The employer manages the money on behalf of the employee. Pension plans became common around the 1940s and were used as the primary form of business retirement plan until the 1980s. The plans were sensible during that time because most workers spent their entire working years with the same company. This gave an employee's retirement investment many years to mature and grow before the employer released the money to the employee.

Pension plans are still used in many companies today and are still a popular option for many workers. For example, if a worker knows that he or she will be with a company for an extended period of time, then that worker may want to invest in the company's pension plan. Pension plans are most often used in government agencies and in companies with a large union presence.

How Pension Plans Work

Let's take a look at how pension plans work. Generally, an employer makes contributions on behalf of the employee. These contributions go into a pool of funds, and that pool is invested. The employee receives the benefits once the employee retires. Until then, the employee generally won't have access to the funds until the employee is vested. This is the amount of time an employee must work for the company before gaining some form of access to the employee's retirement plan funds. The goal is for the pension plan funds to multiply and for the funds to multiply more rapidly because the funds are invested together with the contributions the employer made on behalf of other employees.

The employee also contributes to the pension plan, though usually a smaller portion than the employer contributes. The employee transfers part of his or her current income into the pool. Even though these contributions are part of the employee's income, the employee's investments in the pension plan are considered to be tax-exempt. In other words, pension plans allow employees to save and invest part of their paychecks before income taxes are deducted. The two main types of pension plans are differentiated by the amount of benefit the employee might eventually receive. The two plans are:

  • Defined-benefit plans
  • Defined-contribution plans

Defined-benefit plans guarantee that the employee will receive a particular amount of benefit once he or she retires. This is true even if the employer's investments don't do well. With defined-contribution plans, the employer makes a particular contribution amount each month or each paycheck. However, the employee's retirement benefit amount depends on the growth of the employer's investment. Hopefully, the investment does well so the employees can collect generous retirement benefits!

401(k)

The use of pension plans declined slightly in the 1980s when people began moving between jobs more often. Many companies began using 401(k) plans instead. These are slightly more flexible business retirement savings plans named for the Internal Revenue Code section that governs them. Here are some of the key differences between pension plans and 401(k) plans:

  • Employees can rollover a 401(k) into an IRA when they switch jobs, but a pension plan usually stays invested with the old employer.
  • Employees can control some of the investments in their 401(k) plans, but not usually in pension plans.
  • Employees can increase their contributions to their 401(k)s, but not to most pension plans.

Though designed to be flexible, 401(k)s aren't entirely without restrictions. Be aware that, like pension plans, employees can't access employer contributions until the employee is vested. There are complicated rules regarding when employees can withdraw their funds and financial penalties for withdrawing funds too early. Like pension plans, contributions are part of the employee's income, but employees' investments in the 401(k) are usually considered to be tax-exempt. However, income taxes must be paid on any money that's withdrawn from the account.

How 401(k) Plans Work

Also like pension plans, 401(k) plans work by using employer contributions. The employer decides the amount that they will match to the employee's retirement contribution. For example, many companies use a three percent match program. If the employee contributes three percent of each paycheck, then the employer will also contribute that same amount on behalf of the employee each pay period. Remember that most 401(k) plans allow the employee to choose to contribute more; however, the employer will only match up to three percent.

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