What is a Pension Plan?

What is a Pension Plan?

Pension plans are one way to defer today's income toward a better retirement. Whether the employer pays the entire amount or you contribute to the plan depends on the type of pension plan. They all consist of a plan that an employer sponsors for the benefit of its employees. In order to answer the question, "What is a pension plan?" you have to understand the various types of plans.

Function

Understand that the function of the pension plan never varies. It is a way of the employer providing a tax-deferred amount put away for the benefit of the employee. There are two basic groups of pension plans. The first is the defined benefit. This type of plan gives a specific benefit to the employees at retirement, regardless of the profitability of the investments, often in the form of an annuity payment. There's a formula to calculate the amount based on retirement age, years of service and the annual salary of the employee. Defined contribution plans often offer the employees to participate in the investment risk, and in cases like the 401(k), the funding of the plan.

Time Frame

Check into the amount of time that you have to work for vesting. Vesting means that you have a right to the benefits. Some companies offer immediate vesting on their plans, so any money put aside for you is yours at retirement. Other companies have a vesting schedule where you have ownership of percentages for every year you work. In plans like the 401(k), the money you put in is always yours but the company has a vesting schedule for the match.

Considerations

Ask for information on the pension plan before you accept a position. Since the pension is often money the company puts away, its part of your compensation plan. If you can't decide between two companies and the pay is the same but one has a pension, they actually pay more. If the company has a defined contribution plan like a 401(k) then see if they make a match. Don't forget to participate in the plan if they offer it with a match. Because the money is tax deferred, people in a 25 percent tax bracket only see a difference of $7.50 in their paycheck if they put in $10. The difference is less if there's a state income tax. When the company matches the amount you put in, it may be a percentage. If it's a 50 percent match up to 3 percent of your income, that same $10 that only cost you $7.50 to put in becomes $15.00 of investments.

Size

Reap benefits of a pension plan even from small companies. Many small companies offer plans with different names but the benefits are the same. Because the company is small, simplified plans create lower plan fees and allow them to create pension plans for their people. The Federal tax laws created Simple 401(k)s, Simple IRAs and SEPs specifically for smaller companies. The companies still can participate in money purchase, profit sharing and defined benefit plans are also available to small businesses.

Misconceptions

Feel comfortable that your employer won't take the money and run if you participate in a 401(k). A third party administrator tracks the deposits and does all the federal filing. Sometimes the same company offers investments for the plan or an investment company provides that service. The money doesn't stay in the employer's checking account but goes to investments. US Pension Benefit Guaranty Corporation (PBGC), a federally funded corporation, handles pension bailouts if the corporation goes bankrupt, if just the company funds the plan, like a defined benefit plan. Insurance premiums from companies with pensions and assets recovered from companies that sponsored the plans fund PBGC.

Identification

Learn the names of the plans and how they work. A defined benefit plan is the type of pension where you get a specific amount upon retirement. Profit sharing is a plan that the company funds with a percentage of the profit they make. If they make no profit, then no money goes into the plan. Defined contribution plans come from specific dollar amounts put in by the company and may include money from your check. 401(k)s are one of these plans. Employers often combine two plans, like a profit sharing and 401(k) for their pension plans.