A comfortable retirement is a dream for most of us, a time when we can relax and enjoy the fruits of our labor. To do that, though, we need the financial resources. Social security alone may not meet the needs of many Americans. To achieve a greater level of financial freedom in their golden years, workers invest in pension or other employer-sponsored retirement plans.
Retirement plans and pension plans are not the same thing. While both involve funding an income for employees starting at some point in the future (when the worker retires), a retirement plan includes contributions by the employee (and perhaps by an employer), whereas a pension plan is an employee benefit funded entirely by the employer.
Pension plans are categorized as either defined benefit plans or defined contribution plans. A defined benefit promises a fixed monthly payment to an employee upon retirement, typically based on salary and years of service. A defined contribution plan, on the other hand, is essentially an investment account to which the employer makes a specific deposit on a periodic basis during the term of employment. The accumulated principal and any earned interest are then available to the employee at the time of retirement.
Retirement plans come in a variety of forms, but the most common include:
There are a number of benefits to a company-sponsored pension plan:
There are also some challenges with most defined benefit and defined contribution plans:
As a general rule, employer-sponsored retirement plans are regulated by federal law. The first major legislation governing pensions was the Employee Retirement Income Security Act of 1974, known as ERISA. Among the basic protections included in ERISA are:
Another federal law, the Pension Protection Act of 2006, increased contribution amounts to certain plans, allows the conversion of some employment-based retirement assets to personal IRAs, and makes certain benefits available to low-income workers.
With a defined contribution plan, the participant is entitled to all contributions made by the employer, as well as all growth in the account. With defined benefit plans, the typical computation includes three variables: the employee’s years of service, the employee’s “final average salary,” and a “multiplier.” The final average salary is calculated differently from state-to-state but is typically the average of the employee’s last three- or five-years’ salary. The multiplier, stated as a percentage, then determines the amount of your annual benefit. The typical average multiplier is .02 (two percent), but that number customarily goes up as total years of service increase. As an example, the annual benefit for an employee with 30 years of service, a final average salary of $50,000, and .02 multiplier would be calculated as 30 x $50,000 x .02, giving a $30,000 annual pension during retirement.
State and local public pension funds, most of which are defined contribution plans, have been in a state of crisis for a number of years, as their liabilities increase and asset values drop. It’s estimated that the nation’s public pension system lost about one-fifth of its value (roughly $1 trillion) in the first 12 months of the COVID-19 pandemic.
Proposals for reform of the nation’s public pension plans include:
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