Pensions are usually thought of as the traditional method of saving for retirement, and typically fall under the category of defined benefit plans.
These plans are funded by the employer during the course of employment, and then distributed in fixed amounts to the employee when he or she retires. The distribution amounts are pre-determined dollar amounts or a percentage of the employee’s income. Some exceptions to the rule exist, occasionally a plan will allow employees to withdraw their funds in a lump sum instead of monthly payments.
Either way, an employee’s retirement is not typically affected by the performance of the investments in the plan. Unlike a 401(k) that can fluctuate and compromise the employee’s account balance, the money an employee receives through a pension is guaranteed. It is important to know the details or each pension plan to make sure you are utilizing the benefits and avoiding any pitfalls.
Fully funded plans refer to the security of the plan and if they are able to distribute the full amounts guaranteed to their employees. Employees receive summaries of the fund and can monitor the financial health of their retirement investments. Although they cannot influence the investments, they can decide to opt for a lump sum withdrawal early on. This option is often taken if the company is not performing well and the employee believes his or her future retirement may be in jeopardy.
Setting up a defined benefit pension plan is typically more complicated and costly than other retirement plans on the market. This is partly due to the insurance fees needed to protect the monthly payments that they have guaranteed to their employees.
There are two main options for withdrawing money from a defined benefit pension plan. The benefits of both plans depend on an employee’s personal retirement priorities as well as the company’s financial health. Here are the two most common options to withdraw pension funds.
The most commonly understood method is by taking a monthly annuity. This annuity pays a monthly amount to the employee for the duration of his or her life. These payments are often subject to income tax. Monthly payment amounts are determined by a how long an employee has worked for the company, and the size of his or her salary. These payments are paid until the death of the employee, with some plans offering continued payments for surviving spouses.
The attraction to this type of plan lies in the stability of monthly payments and their longevity. A regular monthly payment can help to create a budget after retirement. However, it is in these same attractive qualities that some disadvantages arise. Payments are not subject to inflation rates. An agreed amount at the start of your employment might not be sufficient after 30 years of inflation. Similarly, if an employer files for bankruptcy and is unable to pay their employees’ pensions, the pension may be lost. The Pension Benefit Guaranty Corporation (PBGC) is a government organization that helps protect the retirement incomes of most people enrolled in pension programs. If your company files for bankrupt and is unable to pay out their promised distributions, the PBGC can help. It is important to note that this service has limits on how much it can pay and cannot not always protect those who have invested.
Lump Sum Payments
Some plans offer employees the opportunity to receive a lump sum instead of monthly payments. If a company is experiencing financial difficulty, they might give their employees the opportunity to take this offer before they reach retirement. If this option is taken, the company is not required to distribute monthly retirement payments when the employee retires.
There are some immediate benefits to taking a lump sum payment. If you roll your lump sum into another investment opportunity, or annuity, you can gain more control over how your retirement is invested. With this in mind, the responsibility of your investment falls on your shoulders. Unlike the traditional method of withdrawals, lump sums do not guarantee payments until your death. Additionally, if you opt for a lump sum before you retire, the option to switch back to a monthly payment is typically denied. It is important to note that if a lump sum is withdrawn and not rolled into another investment, the balance is subject to income tax. This may increase your tax rate significantly, causing you to pay more tax than if your payments were released at lower amounts per month.
Contributions into a plan are made by the employer and are typically a lot greater than those of other retirement plans are. The limits are based on the annual benefits that a participant can receive. In 2018, the limit is set at an average of the participant’s compensation over the highest three consecutive years, or $220,000, depending on which is lower.
Vesting is typically immediate in a defined benefit pension plan, but there are some exceptions to this rule. Some companies require an employee to work several years before he or she can be full vested in the funds of the pension. In some cases, if you leave your job before retirement you may lose the pension benefits you signed up for altogether.
Pension funds are large investment funds made up of an employer’s contributions, as well as union and company contributions over time. These funds are then used to grow the invested contributions and afford the company enough money to pay their employees their guaranteed pensions.
The funds are managed and operated by the employer. An employee does not have a say in what investments are made and how the investments are managed. Although this offers less control, the guarantee of payment at retirement and the lack of responsibility on the employee to have investment knowledge can seem appeal to some workers.
Pension funds under a defined benefit pension plan offer tax benefits for the employer. They can make tax-free contributions to the fund and the profits are generally not subject to capital gains tax. Penalties can apply if too much is contributed to the plan, or if too little is contributed. These penalties are in the form of an excise tax.