Pension benefits are determined by one of two methods. Your average pension benefit will depend entirely on the assumptions of your employer and is determined by a calculation he makes about your income, years or service, and other factors. But, it's still helpful to know what can affect your average pension benefits.
A defined-contribution plan has a set contribution amount and no guaranteed income at retirement. For example, your employer contributes $350 per month to your pension. This amount represents the fixed contribution and generally does not change over your working lifetime. In this scenario, your average pension benefit will be determined by the underlying investments. For example, if your employer invests the proceeds into mutual funds, then your average return on investment will reflect the average returns of that class of mutual funds.
A defined-benefit plan promises you a specific amount of money during your retirement. This amount of money is vested with you after three years of service and cannot be taken away. The benefit is determined by a calculation done by the employer. For example, the employer might determine that you will receive $45,000 per year of retirement income until you turn 90 years old at which point pension benefits will cease. If the underlying investments are not able to support the defined benefit, then the employer must pay for the benefit out of company profits.
Employers often use life insurance or annuity contracts to provide the pension income because of the guarantees found in both types of contracts. However, employers are free to use mutual funds, company stock, bonds, or other investments to secure the proceeds of the pension.
- "Practicing Financial Planning for Professionals, Practitioner's 10th edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- "Ernst & Young's Personal Financial Planning Guide, 5th Edition"; Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004
- "Life & Health Insurance, License Exam Manual, 6th Edition"; Dearborn Financial; 2004
- "Investopedia": Defined Benefit Plan
- "Investopedia": Defined Contribution Plan