A pension plan is a plan in which your employer takes some of its own funds and then invests those funds on your behalf. Upon retirement, an employee is entitled to a specific amount of money, plus however much money the investment earned.
This money, the specific sum and the investment income, is called retirement income. Retirement income payments can be guaranteed until the end of a worker’s life.
How Does a Pension Plan Work?
When an employer sets up a pension plan, the employer must contribute to a pool of money that is set aside for retirement income. The pool of money is invested by the employer. The employer can invest the money in various types of investments. These include stocks and mutual funds.
As the money is invested, earnings on those investments accrue. These earnings are used to pay workers part of their retirement income. Some pension plans contain an option for an employee to invest their own money, in addition to the money the employer invests. Other plans will match, dollar for dollar, a certain amount (usually a percentage) of what the worker contributes each year, up to a certain amount.
How Does the Law Treat Pension Plans?
Employer pension plans are both regulated by a federal law known as the Employee Retirement Income Security Act, or ERISA. Under ERISA, pension plans are considered defined-benefit plans. Under the law, a defined-benefit plan guarantees payment of a minimum amount of retirement income.
The amount of the retirement income is influenced by several factors, including the salary of the employee, how long the employee worked at the company, and the age of the employee when they retire. Depending on how well the investment performs, the amount of retirement income may increase.
The employer also guarantees that if the amount of money in the plan is not enough to pay the minimum amount, the company itself will pay the balance. If the company cannot pay the balance, the federal government can step in and do so.
What are the Advantages and Disadvantages of a Pension Plan?
A defined-benefit guarantees that an employee will be paid some income upon retirement. A drawback of these plans is that employees are typically not entitled to select their own investments.
The plan makes all investment decisions. When doing so, though, the plan must act in the employee’s best interests. This means the plan may not make investments that are unreasonably risky. The employer also may not steal money from the plan.
Another advantage of a defined benefit plan is that it can be inheritable. This means that, depending on the plan, the income from the pension can pass to a person’s heirs, such as a spouse of a child.
Are There Other Retirement Plans?
A pension plan is one kind of retirement plan. Another type of plan, more common now than previously, is called a 401(k) plan. An employer offers either one or the other, and most likely offers the latter. 401(k) plans are subject to ERISA. 401(k) plans are considered to be defined-contribution plans instead of defined-benefit plans.
What is a Defined-Contribution Plan?
In a 401(k) defined-contribution plan, an employee contributes a specific amount of earnings per paycheck to the plan. In a “traditional” 401(k), the contributions the employee makes are not taxed when made. Instead, the money in the plan accumulates, tax-free. The money is taxed when the employee withdraws plan money for retirement.
401(k) plans allow the employee greater control over contribution amounts and investment decisions. In a 401(k) plan, the employee selects how much to contribute. The employee also determines what fund to invest in, from a list of funds. Employees are permitted to change their contribution amounts and investment funds over time.
Many 401(k) plans are “employer-matched.” This means an employer can match the money you contribute, dollar-for dollar. For example, if you want to contribute 3% of your earnings to the 401(k), many employers will match this amount. Some plans offer “full matching,” while others match up to a certain amount of what you can contribute.
The maximum amount an employee can contribute to a 401(k) is $19,500. This amount is set by law and frequently changes from year to year. The combined total an employee and an employer can contribute is currently $57,000.00.
What are the Main Differences Between a Defined Benefit Plan and a Defined Contribution Plan?
The most notable difference between pension and 401(k) plans is that pension plans guarantee a fixed amount of monthly retirement income, while 401(k) plans do not provide guaranteed benefits. If a 401(k) plan participant invests their money in stocks or mutual funds or other investments whose value goes down, the total amount of money in the plan goes down.
Do I Need a Lawyer for Help with Retirement Plan Matters?
If you are uncertain as to how a retirement plan works, or have questions regarding pension plan law, you should contact an employment lawyer. An employer can explain how the plan works. The lawyer can also go over your retirement plan options with you.