In addition to qualified and non-qualified plans, pension plans also can be divided into defined benefit plans and defined contribution plans.
Defined benefit plans are the traditional pension plans usually offered by large, established companies or government employers. Defined contribution plans are newer creations and include 401(k) and 403(b) savings plans.
Under a defined benefit plan a company typically makes a promise to provide a certain benefit to employees when they retire. The benefit, defined in advance, usually depends on the employee's salary and the number of years of employment.
For example, a company may promise to make payments of $40 per month times the number of years of service. Under this formula a person who retired after twenty years would receive $800 in monthly benefits.
Notice the future benefit is defined in advance. Now it's up to the company to contribute enough money and manage the investments well enough to meet these promises.
These defined benefit programs, however, are becoming increasingly rare. Because they promise a defined benefit, the employer is liable for keeping its promises. If the stock and bond markets perform poorly, the employer must chip more money into the plan to meet its obligations.
Defined benefit programs are also expensive to manage. Because benefits are often promised for the life of the worker, defined benefit plans require complex actuarial calculations to ensure the benefits will be paid.
Although defined benefit plans are losing their popularity, they still cover tens of millions of workers at large companies and government employers, so let's take a closer look at them.
Corporate pensions began to become popular in America in the 1930s and these retirement plans were almost exclusively defined benefit plans.
These plans underwent a radical change in 1974 when Congress passed the Employee Retirement Income Security Act after the bankruptcy of a few large companies and the subsequent destruction of their pension plans.
With the passage of ERISA, almost all large pension plans had to purchase insurance from a federally chartered corporation called the Pension Benefit Guaranty Corporation. If a company goes bankrupt and the pension plan is underfunded, the PBGC steps in and makes payments to the retirees.
However the PBGC doesn't guarantee special early retirement or medical benefits given to retirees, and it doesn't cover defined benefit plans offered by employers with 25 or fewer employees.
So you should be aware of your pension plan's viability. Your company is required to give you an annual summary statement disclosing the pension's health. Each year you should also get an individual benefit sheet which shows what you might get from the pension.
Also, companies are required to send notices to employees if the pension funding is less than 90 percent of liabilities. You also can request to see IRS Form 5500, a detailed form which qualified pension plans must file.
Finally, if you're an employee of a state or local government, you may want to look into your pension plan's finances as well. There are about 9,000 public employee pension plans covering 16 million teachers, firemen and other state and local workers. Many of these people are in plans that are seriously underfunded.
When Congress passed ERISA to force private employers to disclose information and otherwise protect their pension plans, Congress exempted state and local governments.
Politicians have taken advantage of this to use pension plans as a convenient way of buying votes now, while pushing the liability off to future taxpayers.
By promising pension increases today, politicians can avoid ugly strikes with powerful unions. When workers retire with increased benefits 20 years from now, the politicians responsible for this shell game will be long gone.
This has lead to some seriously underfunded pension plans. Many midwest and New England states have funded only 60 percent of their pension liability. One of the worst offenders is the West Virginia Teachers' Retirement System. It recently had a liability of $3.7 billion, and yet had under $400 million in assets.
Of course the worst offender is the federal government, which has an unfunded pension liability for it's workers of hundreds of billions of dollars.
If you work for a government agency that has a seriously underfunded pension plan, you should save a little extra money on your own. You'll probably get some kind of pension, but it's doubtful that tomorrow's taxpayers will be willing to pay for untenable promises made by yesterday's politicians.
But even though some defined benefit pensions have their problems, the vast majority of them provide a valuable benefit to workers.
The moral here is that if you have a defined benefit pension plan, count yourself as being lucky. The majority of workers at small businesses don't have any retirement plan at all, aside from Social Security.
Still, most employer pensions don't provide inflation protection. Social Security benefits and most government pensions increase pension benefits in line with inflation. However, most corporate pensions don't provide any kind of inflation protection.
Since prices will double in 14 years with mild inflation of 5 percent, you'll need additional savings to make up for the loss in purchasing power of your pension.
Fortunately, most large employers who provide traditional defined benefit plans also allow their workers to save through defined contribution savings plans like 401(k) accounts.
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