Pension Plans:
Defined Benefits
Defined Contributions
401(k)
Social Security
Pensions plans are usually defined as; “Defined Benefits” and “Defined Contributions”. The Defined Benefits fund is what most Police and Fireman belong to. They contribute a percentage of their salary to the fund and their employers match the contribution. The contribution is usually (6%) of gross salary for the employee and (6%) for the employer. The fund is usually managed by a panel of financial experts; the employee has no say as to how the money is invested. If the employee terminates employment prior to becoming vested, he or she can withdraw “Only” the money they have contributed plus a low interest return. If they leave after becoming vested they can leave the money in the fund and receive a small retirement amount when they do retire. The employer contribution stays in the fund.
The “Defined Contribution” plan is what most industries have or had. Under a "defined contribution" plan the employer provides a fixed contribution (again a fixed percentage of salary) to an individual retirement account for each employee. In some, not all defined contribution plans the employee also is required to make a minimum contribution and may contribute more than the minimum. The employee then is given a choice of investment options for these funds. Choices may include fixed annuities, variable annuities, and a variety of mutual funds. The benefit that the employee receives at retirement basically is the value of the account at that time. No cost of living adjustment or health benefits are included in most of these plans although the retiree usually has the option of purchasing an annuity at retirement.
Both defined benefit and defined contribution plans have a vesting period, usually five years. Remember, employees in a “Defined Benefit Plan” who leave before becoming vested get back only their own contributions with interest. After the vesting period there is a substantial difference between the two types of plans. An employee who is vested in a “Defined Contribution Plan” who leaves before reaching retirement age can either cash out his account (including employer contributions) at its current value, or roll it over into another retirement account with his or her new employer or into an individual retirement account.
A 401(k) plan is a type of defined contribution plan (under the IRS's definition). It is a salary reduction plan, where employees must choose a percentage of their salary to contribute to the plan, and the plan spells out the extent of employer matching, if any (regardless of profits). Employee taxable salaries are reduced by these contributions, the contributions are invested, and any earnings are tax-deferred, i.e., until the employee draws the money out at retirement. Two other types of defined contribution plans are profit-sharing plans, in which the plan specifies, for example, that the employer will contribute 10% of net profits each year (divided among participant accounts), and money purchase pension plans, in which the plan defines the contribution as 10% of participants' annual salary, for example. 401(k) plans are not a defined benefit plan, because the benefit formula (specifying what participants will receive at retirement) is not spelled out in the plan. 401(a) profit sharing plans and money purchase pension plans, and 401(k) plans, are individual account plans, because each participant's benefit is the value of an individual account to which the contributions have been made plus any investment income and less any losses. If investments do well, there will be more in the account at retirement; if investments do poorly, there will be less.
In addition, 401(k) plans are tax-qualified plans covered by ERISA such that assets held by the plans are generally protected from creditors of the account holder, which in the past was generally not true for IRA plans. In the case of employer bankruptcy, all 401(a) (pension and defined contribution plans) and 401(k) plans are protected, because of the rule that contributions must accrue to the exclusive benefit of employees in general. ( Even though pension plans are backed by insurance through the Pension Benefit Guaranty Corporation, workers whose company enters bankruptcy may not receive the full value of their pension. ) US Airways retirees and other company retirees whose company filed for bankruptcy had annual or monthly pension payments dropped. Some took a very substantial monetary loss. ERISA protection of 401(k) assets does not extend to losses in the value of investments that participants choose. Employees investing their 401(k) in their own employer stock face the possibility of losing the value of their retirement accounts that is invested in employer stock along with their jobs if their employer goes out of business.
Defined benefit plans have a definitely determinable benefit amount that usually has a fixed formula, regardless of how the underlying plan assets perform. Defined contribution plan according to Section 414(i) of the IRC have individual accounts. Because plan sponsors want to take advantage of the exemption from the fiduciary duty to diversify plan assets to minimize the risk of large losses by using ERISA Section 404(c), these plans usually provide each worker the ability to control the contents of his account. The account value may fluctuate in value based on the underlying investments. There is a risk that returns may even be negative.
Some companies match employee contributions to some extent, paying extra money into the employee's 401(k) account as an incentive for the employee to save more money for retirement. Alternatively the employer may make profit sharing contributions into the 401(k) plan or just contribute a fixed percentage of wages. These contributions may vest over several years as an inducement to the employee to stay with the employer.
When an employee leaves a job, the 401(k) account generally stays active for the rest of his or her life, though the accounts must begin to be drawn out beginning the April 1st of the calendar year after the attainment of age 70½ (except that under SBJPA 1996, those still employed can defer). In 2004 some companies started charging a fee to ex-employees who maintained their 401(k) account with that company. Alternatively, when the employee leaves the company, the account can be rolled over into an IRA at an independent financial institution, or if the employee takes a new job at a company that also has a 401(k) or other eligible retirement plan, the employee can "roll over" the account into a new 401(k) account hosted by the new employer.
One interesting thing employers have found is that when they stop making contributions to an employee’s 401(K) plan, the employee if he/she was making a contribution stops also.
