A pension plan is a payment arrangement by employers to provide retirement, disability and death benefits to their employees. While payment of future retirement income is the primary benefit of pensions, most plans also offer tax, insurance and workforce retention features.
Retirement Income Benefit
Pension plans gained prominence during World War II, when American employers sought to evade wage controls by awarding fringe benefits packages. Per the U.S. Bureau of Labor Statistics, employers attracted needed labor by offering indirect salary increases in the form of deferred compensation. This practice stimulated the growth of the pension industry.
According to the U.S. Department of Labor, the two most common types of pension plans are defined benefit and defined contribution. Defined benefit plans promise a guaranteed payment at retirement. With these traditional plans, the employer pays the retiree either a lump sum or a monthly payment based on salary and years of service. The plan sponsor commits to underwrite this guarantee regardless of underlying investment returns.
Defined contribution plans, by contrast, do not promise a guaranteed benefit at retirement. These plans allow participants to make contributions to their own accounts. Employers can opt to provide matching contributions too. The participant then proceeds to invest the contributions in an array of investment vehicles.
The sufficiency of defined contribution funds at retirement depends on dollars contributed and investment returns. Therefore, the employee shares responsibility for the outcome of his retirement portfolio. The Employee Benefit Research Institute reports that, as more employers recognize the risks associated with retirement funding, they are trending toward defined contribution plans.
Pension plans also provide valuable tax benefits. With an interest in relieving an overburdened Social Security System and the need to incentivize independent savings, the U.S. government has awarded tax-advantaged status to qualified pension plans. Consequently, many pension plans are both tax deductible and tax deferred.
Qualified plan contributions are tax deductible. Tax deductions reduce adjusted gross income and thereby lower overall tax liability.
Pension plan funds are also tax deferred. Interest, dividends and capital gains grow tax free within the account until the participant withdraws the funds during retirement.
Tax deferral benefits investors in two ways. First, as investment earnings grow tax free, the account has a greater potential for accumulation of capital. Second, because participants typically make contributions during higher-earning years and withdraw funds during lower-earning years, retirees pay taxes at a lower rate.
Pension plans have an insurance benefit in that they often provide payments to disabled beneficiaries and survivors. The pension plans themselves are insured as well. The Pension Benefit Guarantee Corporation was formed in 1974 to provide a pension insurance program that guarantees workers' benefits in private pension plans.
Workforce Retention Benefit
Finally, pension plans provide employers with a tool in retaining workers. “The Watson Wyatt Retirement Attitude Survey” finds that workers who value their retirement plans are more likely to stay with their employer. Therefore, retirement program designs can impact employee behavior and ultimately “deliver favorable economic returns to the organization.”