Pensions

Traditionally, employee pensions are funds that employers contribute to as a benefit for their employees. Upon retirement, money can be drawn from a pension pot or sold to an insurance company to be distributed as periodic payments until death (a life annuity). Please visit our Annuity Calculator or Annuity Payout Calculator for more information or to do calculations involving annuities. In the U.S., the main advantage of a pension as a vehicle of saving for retirement lies in the fact that pensions provide preferential tax benefits for money placed into them as well as any subsequent earnings on investment. In many modern instances, the term “pension” is used interchangeably with the term “retirement plan” rather than as a form of it.

Defined-Benefit Plan

When people throw around the term “pension plan,” the Defined-Benefit (DB) plan is typically what they are referring to. In this type of pension plan, employers guarantee their employees a defined amount, or benefit, upon retirement, regardless of the performance of the investments involved, and with certain tax advantages. This can vary from plan to plan, but while employers are the main contributors of the DB plans, employees may also be able to contribute. The DB plans in the U.S. do not have contribution limits.

As a result, employers become fully responsible for these future payments to their employees; even if the company goes under, or is bought out by another company, or goes through any major overhaul, employees still have legal rights to their share of the DB plans. With that said, it is possible that these legal rights won’t mean much if a company goes through a string of particularly bad financial hardships.

Retirement income is usually determined by several variables pertaining to each individual employee, and some of the most important are their age, earnings history, and years of service. This also differs from company to company.

Generally speaking, the longer an employee works for a company or the higher their salary, the higher their projected benefits in retirement.

Social Security is the most common DB plan in the U.S. Most American workers are qualified for collecting Social Security benefits after retirement. However, Social Security is only designed to replace an estimated 40% of a worker’s income in retirement, which means that depending entirely on Social Security in retirement is likely not viable. For more information or to do calculations concerning Social Security, please visit the Social Security Calculator.

The three calculators above are mainly designed for the Defined-Benefit Plan.

Defined-Contribution Plan

In this type of pension plan, employers may make specific contributions to each of their employees’ tax-advantaged pension plans. There are a number of ways for employers to make contributions, but the most common method is providing a matching contribution up to a certain percentage of income for each employee, while a less common method is based on the years of service of each employee. Distribution amounts in retirement are based on historic employee and employer contributions, along with investment gains and losses over time. Unlike their counterpart, the defined-benefit (DB) plan, investments and the subsequent earnings income here are heavily dependent on the performance of investments within the plans. As a result, there is no guaranteed payout of future funds in the scenario when the value of assets drops drastically. Therefore, for the most part, tenure with a company or age has less to do with the accrual of benefits during any certain period in a DC plan (unlike DB plans).

However, participants are allowed more individual control and flexibility regarding their benefits; each employee can choose where their contributed dollars are invested. Most will likely put them into diverse, managed portfolios that contain stocks, bonds, and various financial instruments. Others can choose to take more active investing roles by picking and choosing stocks, though it is generally not recommended to engage in such risky financial activities using retirement savings. Also, unlike their counterpart, DC plans are more flexible; an employee with a tendency to change jobs often can still retain the same DC plan the entire time by transferring it from employer to employer. However, keep in mind that not all employers allow 401(k) rollovers.

DC plans are now the most popular pension plans in the U.S., especially in the private sector. In the U.S., the most popular defined-contribution (DC) plans are the 401(k), IRA, and Roth IRA plans. For more information or to do calculations involving each of them, please visit the 401(k) Calculator, IRA Calculator, or Roth IRA Calculator.

In the U.S., today very rarely is the term “DC plan” used to refer to pension plans. They are more likely to be referred to by their programs, such as “401(k),” the “457 plan,” or IRA, etc.

The Fall of Defined-Benefit Plans and the Rise of Defined-Contribution Plans

In the U.S., DB plans have been heavily scrutinized recently, and their use has declined in favor of their counterpart, the DC plan. While the public sector still houses most of the DB plans in existence today, the golden age of the DB plans seems to be long gone.

There are several reasons why they have mostly fallen out of favor. To begin with, too much of the success of DB plans depends on several volatile factors. The first is whether employees quit for whatever reason or get fired, which are generally unpredictable events. The second is whether the company goes belly up; although there is a Pension Benefit Guaranty Corporation as insurance for these situations in case private pensions fail, they only have so much money to hand out. In turn, this can explain why it is still common for the public sector to offer DB plans since it is unlikely for them to go under. If such a thing were to happen, employees may not get their guaranteed benefits, but may instead receive partial benefits, or none at all for the less fortunate. People closer to retirement may have a better sense of their company’s ability to stay in good financial health, while folks who aren’t scheduled to retire for 30 to 40 years may have a foggier view of the future of the company and the safety of their pension. In order to realize the biggest benefits of these plans, an employee would have to stay with their company for a long period of time, such as 25 years, which is increasingly uncommon today. Also, plans are subject to becoming “frozen” for a variety of reasons. That is, some or all employees covered under a DB plan will stop earning some or all of the benefits from the point that plans are frozen. This can happen due to many different reasons, which may include rising healthcare costs due to increased lifespans or unfavorable interest rates. Last but not least, DB plans tend to require more administrative costs than DC plans.

Lump Sum vs. Monthly Benefit Payout

Most DB plans offer the option of a one-time lump sum payment or monthly benefit payouts. In the context of pensions, the former is sometimes called the commuted value, which is the present value of a future series of cash flows required to fulfill a pension obligation.

The major advantage of a monthly pension benefit is that it can quite possibly be guaranteed income for life. While anyone can take the immediate lump sum and spend it all in a short period of time, this wouldn’t be possible with the monthly benefit payout option. Also, because these monthly benefits are the obligation of employers, they are not subject to any external influences that may affect their value, such as any volatility in the stock market.

One notable advantage to the lump sum option is that it can offer a lot of flexibility. The money can be spent, saved, or invested in whatever ways desired. For some people though, particularly those who habitually spend or don’t have a financial advisor, this may be a bad thing. An option to consider is to roll the lump sum over into an IRA, which can legally have beneficiaries. In general, remaining pension payments cannot be left to heirs (outside of a spouse if married and under a joint-and-survivor option). In the case of the death of the primary account holder, any money remaining inside the IRA can be passed onto their heirs. In addition, by rolling it into an IRA, the tax-deferred nature of the money is preserved. Also, lump sums tend to make more sense for people with shorter life expectancies. If they are forecasted not to live long enough to realize the financial benefits of a schedule of cash flows, due to serious disease or otherwise, simply taking the lump sum instead can result in more income.

Single-Life or Joint-and-Survivor Plans?

Upon retirement, pensions generally provide two methods of distributing benefits. Single-life plans pay a monthly benefit for the remainder of the beneficiary’s life, but as soon as they pass away, pension payments halt. A drawback to this is that surviving spouses will be left without a major source of income. Unsurprisingly, this option is most commonly used by retirees without spouses or dependents. However, there are exceptions for single-life pensions that have guarantee periods; if the retiree passes away within the guarantee period (usually five or ten years), dependents are eligible to receive income until it ends. Monthly benefits for plans with guarantee periods tend to be lower than for those without a guarantee period.

On the other hand, joint-and-survivor plans have the retiree’s spouse as an additional beneficiary for a total of two, and monthly benefits will last until both beneficiaries pass away. Essentially, a larger monthly benefit is given up for the peace of mind that comes with ensuring the financial security of a spouse or domestic partner even after the death of the main beneficiary. Because the benefits from a joint-and-survivor plan must try to outlive two beneficiaries, they generally contain lower monthly benefits than those of a single-life pension. Upon the death of the first spouse, the surviving member will receive a certain percentage of the original payout, and this is called the survivor benefit ratio. This is determined at the beginning of the payout phase. Common survivor benefit ratios are 50%, 66%, 75%, and 100%, the last of which is the same payout as if both members are surviving. As an example, given two retired spouses who receive $1,000 from a joint-and-survivor plan with a 50% survivor benefit ratio, if one of them passes away, the survivor will begin to receive $500 (50%) payouts from then on.

Both have their pros and cons, and it is up to each individual (and maybe their spouses also) to determine which is right for them. In general, single-life plans tend to pay out the highest monthly benefit, followed closely by single-life plans with a period guarantee.

1. Cost-of-Living Adjustment

Due to inflation, prices of goods and services are expected to rise over time, and the cost-of-living adjustment (COLA) helps to maintain the buying power of retirement payouts. While the COLA is mainly used for the U.S. Social Security program, which is technically a pension plan that is public, it also plays an important role in private pension plans. Generally, it is the norm to gradually increase pension payout amounts based on the COLA to keep up with inflation. Unfortunately, most private pensions are not adjusted for inflation. Overfunded pensions, which are pension plans that have more assets than obligations, may be able to afford a COLA if their beneficiaries advocate for it successfully, but the same usually cannot be said for underfunded pensions. Each of the three calculations allows the option to input a custom figure as COLA. If no such adjustment is desired, just use “0” as the input.