We often talk about retirement and pensions as if they were the same thing. When we retire, we receive a pension and we become pensioners. But a pension has a special meaning. It refers to a particular type of retirement plan. An employer makes contributions to a pool of funds. He invests the funds for the employees of the company and uses these funds to pay their pensions.
A pension can also allow employees to make their own contributions, but the key thing about a pension is that it is the responsibility of the employer. The worker does not have to worry about the future. They can focus on their work, knowing that their retirement is taken care of. They will receive a salary as long as they work. And when they are done working, they will receive a pension for the rest of their lives.
Pensions also usually have vesting periods. This is the amount of time an employee must work for an employee in order to receive their pension payments. For pensions, this usually means one year, although some employers may grant vesting immediately while others may delay vesting or stagger vesting for up to seven years.
This pension, like other forms of retirement funds, can take two forms.
Defined contribution plans
In “defined contribution” schemes, the employer pays a fixed monthly contribution to the fund. The employer can match the employee’s contribution, but the payment will depend on the performance of the fund. If the fund performs better than average, the retiree will receive more funds. If the fund is performing poorly, the retiree may receive less than expected.
Defined benefit plans
In “defined benefit” schemes, the employer pays a fixed pension regardless of the performance of the pension fund. If the fund falls, the employer must make up the difference between the amount the fund can pay out and the amount the retiree is to receive.
When people talk about pensions, they are usually referring to defined benefit plans.
The advantages of a pension
For employees, the defined benefit pension is the reference in terms of pension plans. They can work, knowing that when they reach retirement age, their future is certain. They may not even have to pay dues on their own, so they won’t feel their payments. Each month, they’ll get their payslip, ignore the deductions that outline how much the business took from their gross income, and focus on the bottom line.
Working for a company that pays a pension eliminates one of life’s biggest concerns: how to earn an income when you’re too old to work.
Pensions also benefit from an advantageous tax status. Employers can deduct contributions from their taxable profits while employees contribute to the pension from their pre-tax income. This reduces the amount of income tax they have to pay.
Funds in a pension fund also grow tax-free. As long as the money remains in the account, the pension holder does not have to pay income. Tax payments only begin when the employee retires and begins making withdrawals. At that time, because their income is lower, their tax liability will also be lower.
The costs of a pension
Because the costs of a pension fall on the company providing it, pensions were popular during the heyday of American manufacturing. Unions could then demand generous pension schemes, and corporations had sufficient commercial demand to provide them. As this demand met competition from more efficient Japanese automakers and pension plan performance did not match commitments, companies were left with heavy debt.
In early 2020, Ford announced that pension liabilities would cost the company $2.2 billion. In 2003, General Motors had $90 billion in retirement obligations, but only $66 billion in retirement assets. The company had to borrow $10 billion on the bond market, not to invest in new production or a new model, but to help cover its pension obligations. It didn’t help. When General Motors filed for bankruptcy six years later, the company had ten retirees for every active employee.
Because defined benefit plans pose such risks to companies, they are now rare. Most private companies have preferred to transfer the risk to employees and enroll them in defined contribution plans. A number of companies that had defined benefit plans have now frozen them. They no longer accept new members and payments will no longer increase based on the years the employee continues to work.
Defined-benefit pensions are now mainly found in the public sector: among teachers, veterans and other civil servants.
How to get a pension
There was a time when the best way to get a defined benefit pension was to get a union job. Whether in the auto industry, the steel industry, or anywhere else, an employee could depend on the union to demand a reliable pension from their employer.
These days, you are more likely to have to seek a position in government. The taxpayer is about the last employer still willing to give people the guarantee of a fixed pension. All other types of employees will have to assume some of the responsibility for their retirement themselves. They will need to think ahead, decide how much they want to contribute, and monitor the growth of the fund to make sure they are on the right track. The demise of defined benefit pensions has forced everyone to understand how pension funds work.
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