A pension plan is a means for providing income when an employee reaches retirement age and will no longer be working. If you work for someone else, you may be eligible to participate in an employer-sponsored retirement plan. If you are self-employed, it is your responsibility to set up and administer your own retirement plan.
For many employer-sponsored plans, eligibility is based on age and the completion of one year of service with the company. If a company is a corporation and offers a retirement plan, it will be either a defined benefit plan or a defined contribution plan.
A defined benefit plan provides the traditional pension. At retirement age, the company will pay the employee a fixed, lifetime income. The amount generally depends on the employee’s highest attained salary and length of employment. Defined benefit plans are typically financed entirely by the employer. The employee generally pays nothing into this type of plan. The company assumes responsibility for ensuring that money is available to fund the benefit when the employee is ready to retire.
By comparison, a defined contribution plan does not provide a fixed lifetime pension. Instead, it requires that contributions (the employee’s, the company’s, or a combination of both) will be made to a retirement account in the employee’s name. For example, a 401(k) plan is a defined contribution plan in which the employee contributes a percentage of salary (on a pre-tax basis) and the company, at its discretion, may make a matching contribution. The company assumes no responsibility for the account. The balance of the account depends on how much is contributed annually and how the money was managed.
Whose Money Is It?
Vesting refers to an employee’s entitlement to the funds in a plan. Generally, vesting is based on years of service with an employer. With a few exceptions, vesting rules are the same for defined benefit and defined contribution plans.
In a defined contribution plan, all employee contributions, and earnings on such contributions, are 100% vested from the start of participation in the plan. On the other hand, vesting for employer contributions usually occurs over time. Should an employee leave a place of employment prior to retirement, he or she generally would be permitted to roll over the entire amount vested to date to another employer plan or to an Individual Retirement Account (IRA). If allowed by the plan, the employee may leave the vested amount in the plan (to be drawn upon at retirement).
With a defined benefit plan, the commencement of benefits is determined by the terms of the plan. Although the employee accrues a vested benefit over time, the plan may specify that benefits will not commence until the employee attains normal retirement age (no later than age 65 or the fifth anniversary of the date when plan participation commenced).
Many defined benefit plans permit “early” retirement. However, an early retirement benefit may be reduced because the employee is expected to receive benefits over a longer period of time. If an employee leaves the company before normal retirement age, he or she could elect to receive an early retirement benefit if the age and service requirements (for early retirement) of the plan have been met.
In some defined benefit plans, a former employee will have his or her retirement benefit frozen. In that case, the employee generally cannot roll over benefits from one employer’s defined benefit plan to another employer’s defined benefit plan. Distribution of the employee’s benefit will commence upon reaching normal retirement age. An individual with a frozen pension with a previous employer can contact the employer to find out how the retirement benefit will be calculated.
While neither plan is inherently better than the other, there has been a shift away from defined benefit plans toward defined contribution plans. Therefore, it is important to understand the risks and benefits between the two basic types of retirement plans.