pension plan

n.
An arrangement for paying a pension to an employee, especially one funded fully or in large part by an employer.

A type of retirement plan, usually tax exempt, wherein an employer makes contributions toward a pool of funds set aside for an employee's future benefit. The pool of funds is then invested on the employee's behalf, allowing the employee to receive benefits upon retirement.

Investopedia Says:
In many ways, a pension plan is a method in which an employee transfers part of his or her current income stream toward retirement income. There are two main types of pension plans: defined-benefit plans and defined-contribution plans.

In a defined-benefit plan, the employer guarantees that the employee will receive a definite amount of benefit upon retirement, regardless of the performance of the underlying investment pool.

In a defined-contribution plan the employer makes predefined contributions for the employee, but the final amount of benefit received by the employee depends on the investment's performance.

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Provides replacement for salary when a person is no longer working. In the case of a Defined Benefit Pension Plan, the employer or union contributes to the plan, which pays a predetermined benefit for the rest of the employee's life based on length of service and salary. Payments may be made either directly or through an annuity. Pension payments are taxable income to recipients in the year received. The employer or union has fiduciary responsibility to invest the pension funds in stocks, bonds, real estate, and other assets; earn a satisfactory rate of return; and make payments to retired workers. Pension funds holding trillions of dollars are one of the largest investment forces in the stock, bond, and real estate markets. If the employer defaults, pension plan payments are usually guaranteed by the Pension Benefit Guaranty Corporation (PBGC).

In the case of a Defined Contribution Pension Plan, such as a 401(k) or 403(b) plan, employees choose whether or not to contribute to the plan offered by the employer, who may or may not match employee contributions. Pension benefits are determined by the amount of assets built up by the employee during his or her years of contributions. Self-employed individuals can also set up pension plans such as Keogh Plans. An Individual Retirement Account (IRA) is a form of pension plan. See also Vesting.

The term "pension plan" is now used to describe a variety of retirement programs that companies establish as a benefit for their employees—including 401(k) plans, profit-sharing plans, simplified employee pension (SEP) plans, and Keogh plans. In the past, however, pension plans were differentiated from other types of retirement plans in that employers were committed to providing a certain monetary level of benefits to employees upon retirement. These "defined benefit" plans, which were common among large employers with a unionized work force, have fallen into disfavor in recent years.

Some individuals also choose to establish personal pension plans to supplement their retirement savings. Making sound decisions about retirement is particularly important for self-employed persons and small business owners. Unlike employees of large companies, who can simply participate in the pension plans and investment programs offered by their employers, entrepreneurs must set up and administer their own plans for themselves and for their employees.

Though establishing and funding pension plans can be both time-consuming and costly for small businesses, such programs also offer a number of advantages. In most cases, for example, employer contributions to retirement plans are tax deductible expenses. In addition, offering employees a comprehensive retirement program can help small businesses attract and retain qualified people who might otherwise seek the security of working for a larger company.

The number of small firms establishing pension plans grew considerably during the 1990s, but small employers still lag far behind larger ones in providing this type of benefit for employees. According to a 1998 survey by the Employee Benefit Research Institute, 29 percent of small businesses (those with fewer than 100 employees) offered retirement plans, compared to 83 percent of businesses employing more than 100 workers. Small business owners reported uncertain company revenues, low worker demand, high administrative costs, and complex government regulations as some of the main reasons they did not sponsor retirement plans for their employees.

Pension Plan Options for Small Businesses

Small business owners can set up a wide variety of pension plans by filling out the necessary forms at any financial institution (a bank, mutual fund, insurance company, brokerage firm, etc.). The fees vary depending on the plan's complexity and the number of participants. Some employer-sponsored plans are required to file Form 5500 annually to disclose plan activities to the IRS. The preparation and filing of this complicated document can increase the administrative costs associated with a plan, as the business owner may require help from a tax advisor or plan administration professional. In addition, all the information reported on Form 5500 is open to public inspection.

A number of different types of pension plans are available. The most popular plans for small businesses all fall under the category of defined contribution plans. Defined contribution plans use an allocation formula to specify a percentage of compensation to be contributed by each participant. For example, an individual can voluntarily deduct a certain portion of his or her salary, in many cases before taxes, and place the money into a qualified retirement plan, where it will grow tax-deferred. Likewise, an employer can contribute a percentage of each employee's salary to the plan on their behalf, or match the contributions employees make.

In contrast, defined benefit plans calculate a desired level of benefits to be paid upon retirement—using a fixed monthly payment or a percentage of compensation—and then the employer contributes to the plan annually according to a formula so that the benefits will be available when needed. The amount of annual contributions is determined by an actuary, based upon the age, salary levels, and years of service of employees, as well as prevailing interest and inflation rates. In defined benefit plans, the employer bears the risk of providing a specified level of benefits to employees when they retire. This is the traditional idea of a pension plan that has often been used by large employers with a unionized work force.

In nearly every type of qualified pension plan, withdrawals made before the age of 59 ½ are subject to an IRS penalty in addition to ordinary income tax. The plans differ in terms of administrative costs, eligibility requirements, employee participation, degree of discretion in making contributions, and amount of allowable contributions. Free information on qualified retirement plans is available through the Department of Labor or on the Internet at www.dol.gov.

The most important thing to remember is that a small business owner who wants to establish a qualified plan for him or herself must also include all other company employees who meet minimum participation standards. As an employer, the small business owner can establish pension plans like any other business. As an employee, the small business owner can then make contributions to the plan he or she has established in order to set aside tax-deferred funds for retirement, like any other employee. The difference is that a small business owner must include all nonowner employees in any company-sponsored pension plans and make equivalent contributions to their accounts. Unfortunately, this requirement has the effect of reducing the allowable contributions that the owner of a proprietorship or partnership can make on his or her own behalf.

For self-employed individuals, contributions to a qualified pension plan are based upon the net earnings of their business. The net earnings consist of the company's gross income less deductions for business expenses, salaries paid to nonowner employees, the employer's 50 percent of the Social Security tax, and—significantly—the employer's contribution to retirement plans on behalf of employees. Therefore, rather than receiving pre-tax contributions to the retirement account as a percentage of gross salary, like nonowner employees, the small business owner receives contributions as a smaller percentage of net earnings. Employing other people thus detracts from the owner's ability to build up a sizeable before-tax retirement account of his or her own. For this reason, some experts recommend that the owners of proprietorships and partnerships who sponsor pension plans for their employees supplement their own retirement funds through a personal after-tax savings plan.

Personal Pension Plans for Individuals

For self-employed persons and small business owners, the tax laws that limit the amount of annual contributions individuals can make to qualified retirement plans, as well as the requirement that qualified plans established by an employer must cover all employees, may make these plans less desirable. "If you're relying on a tax-qualified plan to fund your retirement, it's time to rethink that strategy," Arthur D. Kraus wrote in an article for Small Business Reports. "You may want to use a non-qualified plan to supplement or even replace your qualified savings." Kraus recommended that small business owners consider setting up a personal pension plan to provide a source of income and security in their retirement. These plans have nearly unlimited annual contributions and do not have to be offered to employees. "You can sock away as much money as you want each year and use the plan just to cover yourself—as most small business owners do—or offer it to a few top managers," Kraus stated. "And that's not the best part. You can draw tax-free income in retirement from a personal pension plan."

Establishing a personal pension plan involves purchasing a variable life insurance policy and paying premiums, which basically take the place of annual contributions to a retirement plan. The amount paid in is invested and allowed to grow tax-free. Both the premiums paid and the investment earnings can be accessed to provide the individual with an annual income upon retirement. The only catch is that, unlike qualified retirement plans, the annual payments made on a personal pension plan are not tax-deductible. However, Kraus claimed that the tax savings in retirement often offset the loss of the tax deduction during the working years.

Although other types of insurance policies—such as whole life or universal life—can also be used for retirement savings, they tend to be less flexible in terms of investment choices. In contrast, most variable life insurance providers allow individuals to select from a variety of investment options and transfer funds from one account to another without penalty. Many policies also allow individuals to vary the amount of their annual contribution or even skip making a contribution in years when cash is tight. Another worthwhile provision in some policies pays the premium if the individual should become disabled. In addition, most policies have more liberal early withdrawal and loan provisions than qualified retirement plans. The size of the annual contributions allowed depends upon the size of the insurance policy purchased. "The bigger the policy, the higher the premiums—and thus, your plan contributions," according to Kraus. "The IRS also sets a maximum annual contribution level for each size policy, based on your age, gender, and other factors."

Upon reaching retirement age, an individual can begin to use the personal pension plan as a source of annual income. Withdrawals—which are not subject to income or Social Security taxes—first come from the premiums paid and earnings accumulated. After the total withdrawn equals the total contributed, however, the individual can continue to draw income in the form of a loan against the plan's cash value. This amount is repaid upon the individual's death out of the death benefit of the insurance. "Is a personal pension plan right for you? That depends on whether other savings will meet your retirement needs," Kraus noted. "But given the benefits of the plan—tax-free earnings, tax-free retirement income, protection for your heirs, and even disability benefits—it's clear that this savings strategy is well worth considering."

Further Reading:

Battle, Carl W. Senior Counsel: Legal and Financial Strategies for Age 50 and Beyond. Alworth Press, 1993.

Blakely, Stephen. "Pension Power." Nation's Business. July 1997.

Blakely, Stephen. "Small Firm Gap Reflects Lack of Demand." Nation's Business. September 1998.

Connor, John B., Jr. "Pay Me Later." Small Business Reports. July 1994.

Corry, Carl. "Pension Tension Mounts." LI Business News. July 30, 1999.

Crouch, Holmes F. Decisions When Retiring. Allyear Tax Guides, 1995.

Gordon, Marcy. "Pensioners Go Underpaid." Detroit Free Press. June 17, 1997.

Kraus, Arthur D. "A Pension Plan of Your Own." Small Business Reports. March 1994.

Livingstone, Abby. "Ways to Expand Pension Savings." Nation's Business. October 1997.

Martin, Ray. Your Financial Guide: Advice for Every Stage of Your Life. Macmillan, 1996.

See also: Employee Retirement Income Security Act; Retirement Planning

n.pl

Saving and investment programs designed to provide income at the time of retirement. These may be employer- or individualbased, in which portions of the funds may be protected from taxation at the time of earning but subject to taxation at the time of withdrawal.

Pension Plans are used to fund retirement programs and may involve employers, the government, or both. Created to provide payments to workers or their families upon retirement, they also provide benefits in the event of death or disability. Self-employed persons generally have individual arrangements. Funding for pension programs may include employee contributions supplemented by matching funds from the employer, deferred profit sharing programs, stock purchase programs, or employee savings. Social security, a federal pension program established in 1935, may supplement employer and private pension plans.

Different pension plans exist for federal, state, and local government employees; military personnel; and public school teachers. An individual may enhance a pension plan through individual retirement accounts (IRAs) or 401(k) programs or through programs such as the Teachers Insurance and Annuity Association College Retirement Equities Fund (TIAA-CREF). Tax deferments allow retirement contributions to be funded with tax-free dollars, while retirement savings accounts may accumulate interest while delaying tax payments on their growth until funds are withdrawn, promising a larger income at retirement.

Military Pensions

Congress established the General Law pension system in 1862 to provide payments for veterans who had been disabled as a direct result of military service. Payments were determined by the degree of disability as determined by a local medical board. This was usually based on the ability to perform manual labor.

The federal government created a more general pension plan for Union Army veterans in 1890. Although originally designed to assist disabled veterans, it included the beginnings of a collective disability and old-age program for Union veterans of the Civil War. This law provided a pension regardless of whether the condition was caused by military service. Although the law did not recognize old age as a basis for receiving a pension, the Pension Bureau instructed doctors to authorize pensions for applicants over age sixty-five, unless the individual appeared exceptionally vigorous. One effect seems to have been the encouragement for more men to retire, so that, by the early twentieth century, retired Union Army veterans outnumbered nonveteran retirees.

By 1900, this program grew to the extent that it took up nearly 30 percent of the federal budget. Housed in its own building, the pension program provided benefits to veterans as well as their widows and dependant children. Almost a third of those between fifty-five and fifty-nine received pension payments, as did about 20 percent of those between sixty and sixty-five; 15 percent of those aged sixty-five to sixty-nine; and a bit less than ten percent of those seventy or older. The pension program seems to have contributed to these veterans' political power, and they made benefits an important issue in the early twentieth century. Not unlike today's senior citizens, they were well organized and lobbied Congress effectively, despite their small numbers. They tended to support high tariffs and campaigned to have the additional funds directed into the pension fund.

Private Pensions

In the final quarter of the nineteenth century, private pension plans were developed because of employees' growing desire for status, security, and higher salaries combined with management's needs for loyal, dedicated, and productive employees. Partly an expression of welfare capitalism, these early plans were also the result of a belief that benevolent and generous programs, such as pensions, could help create the durable, industrious, and devoted workforce management wanted.

The initial private pension plans were developed by the railroads. The American Express Company established the first one in 1875, followed five years later by the Baltimore and Ohio Railroad (B&O). In 1900, the Pennsylvania Railroad offered its employees a plan. Although these plans arose primarily from a desire to retain employees, they also reflected growing concerns about unions, the welfare of workers, and a wish to display corporate benevolence toward employees. The pension plan created by the B&O had a provision for old-age protection that would serve as an example for future plans, as it allowed employees to retire at sixty-five or, if they were disabled, at age sixty. Another interesting aspect of the plan was its treatment of old age as a disabling illness, providing retirees the same benefits as those who had suffered long-term disabilities. A unique feature of the Pennsylvania Railroad plan was the establishment of corporate control over the plan's administration, setting a precedent for the evolution of modern personnel administration. Other railroads that adopted pension plans soon copied this feature.

Despite the pioneering efforts of the railroads, few other corporations offered any sort of pension plan by 1900. Undoubtedly, the long-term commitment required by such plans discouraged many companies from offering them. Profit sharing plans were more popular, since the entire workforce could benefit from them, and occasionally, a firm might tie a pension program to its profit sharing plan.

Government Pensions

Although the federal government had established age as a basis for making pensions available to veterans of the Union Army in 1890, it would be another thirty years before a retirement and pension program was established for government employees. As with the private sector, government's interest in pension plans was related to efficiency and security. Generally speaking, civil service employees tended to hold on to their jobs because of the security they offered, but the late nineteenth century saw aging with in the bureaucracy become a problem. Many civil service workers were Union Army veterans, who were unlikely to be removed from their jobs for political reasons. These men stayed on in their positions, contributing to an aging and increasingly inefficient bureaucracy. By the beginning of the twentieth century, there was a growing interest in a retirement and pension policy for civil service employees, leading to the creation of the United States Civil Service Retirement Association (USCSRA) in 1900. This association spent several years collecting data and investigating methods by which a federal retirement policy could be established and funded.

These efforts drew the support of the administrations of Theodore Roosevelt and William Howard Taft. Roosevelt established the Keep Commission to investigate the question. The commission's final report offered statistical evidence that, as workers age, they become less efficient.

Taft furthered the movement with the formation of the Commission on Economy and Efficiency, which recommended a plan for civil service retirement. Taft endorsed the plan, and its call for compulsory retirement at age seventy and the creation of an employee financed pension fund. The USCSRA supported this recommendation, but action was prevented by a new group, the National Association of Civil Service Employees (NACSE), which favored a government funded program.

The debate continued into the Wilson Administration. Political concerns led Woodrow Wilson to with hold support for the issue until 1918, when he responded favorably to a proposed retirement bill. Southern Democratic opposition, however, helped delay passage of the bill until 1920. Civil service employees were now able to retire at age seventy, while others could retire as early as age sixty-two. Funding came from a small salary deduction. An amended law passed in 1926 increased the benefit package, after it became apparent that the original benefits provided in the 1920 law were inadequate.

The problems of unemployment and poverty among the elderly during the Great Depression led to the enactment of the Social Security Act. From the beginning of the New Deal, President Franklin D. Roosevelt's administration wanted a federally sponsored program that would furnish social insurance for the elderly and unemployed. The bill, passed in 1935, would develop into one of the most farreaching and complex laws Congress had ever enacted. The object of social security was to create a system of insurance rather than welfare. While the law was originally designed to target a small group of people truly in need and unable to support themselves, the program has expanded to assist the elderly, the disabled, and the survivors of those whose payroll deductions contributed to the federal funds that are paid out. The key feature of the program linked benefits to those payroll deductions. This served to create a sense among contributors that they had a vested interest in the program and the right to collect benefits and pensions as promised under the law.

Current Pension Trends

Even so, the present concept of retirement did not emerge until the late 1960s or early 1970s. Prior to this, the Social Security Act had been amended several times to allow more and more workers into the system, but no significant improvement in retirement benefits had taken place, and the concept of social security as supplemental retirement income had not been challenged. But, continued high poverty rates among senior citizens added credibility to their complaints that the benefits were no longer sufficient. Between 1965 and 1975, benefit levels were increased five times, and in 1972, they were indexed in relation to the Consumer Price Index.

A reorganization of private pension plans also occurred in the 1970s. Noteworthy was the passage of the Employee Retirement Income Security Act (ERISA), which legalized vesting plans while giving workers some protection against the loss of benefits. Inflation also led private plans to provide automatic benefit increases to offset the rising cost of living. Additionally, because of increased participation, private plans began to encourage early retirement and offered greater benefits to those who took this option, instead of the reduced benefits that had been common before.

By 2000, there were growing concerns about the future of Social Security, primarily because of the program's expansion during the last decades of the twentieth century. By 2030, the number of persons eligible to receive benefits may double, while the number of those paying into the system will increase by only 20 percent. This has led to talk of privatizing social security or implementing reforms such as taxing all wage earners or allowing a semiprivate government agency to oversee and manage the program's investments to assure adequate funding for future beneficiaries. Another suggestion is to raise the retirement age to sixty-seven or seventy. Similarly, owing to an increasing number of major bankruptcies, by the early 2000s, the private sector was increasingly concerned about the well-being of corporate pension programs. In addition to this, the government was experiencing increasing pressure to take more significant steps to protect private pension plans as well as to assure the continued functioning of the social security system.

Bibliography

Costa, Dora L. The Evolution of Retirement: An American Economic History, 1880–1900. Chicago: University of Chicago Press, 1998.

Graebner, William. A History of Retirement: The Meaning and Function of an American Institution, 1885–1978. New Haven, Conn.: Yale University Press, 1980.

Haber, Carole, and Brian Gratton. Old Age and the Search for Security: An American Social History. Bloomington: Indiana University Press, 1993.

Sass, Steven A. The Promise of Private Pensions: The First Hundred Years. Cambridge, Mass.: Harvard University Press, 1997.

Schieber, Sylvester J. The Real Deal: The History and Future of Social Security. New Haven, Conn.: Yale University Press, 1999.