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Two Types of Pensions
Along with paid vacation time off and health
insurance, retirement benefits are probably the most sought after
employer provided benefit. Pensions provide employees with the
opportunity to accumulate the funds needed to be able to afford to
stop working. Pension income, along with income from Social
Security usually make up a major portion of the income received in
retirement.
Employer pensions come in two main varieties:
• Defined Benefit
• Defined Contribution
Defined Benefit Plans
Defined benefit plans are plans where the employer
guarantees to pay the employee at retirement a fixed monthly
income for life. Larger organizations in the United States usually
base the monthly income to be paid to the retiree using either a
dollars times service calculation, final average pay calculation
or some combination or variation of these two methods. There are
other ways to calculate the benefit which are mainly used by
employers outside the U.S.
A dollars times service calculation is made by
multiplying the number of years the employee worked for the
company times some dollar amount. For example a plan could call
for paying a monthly retirement income of $125 times the number of
years worked. Under this method an employee with 30 years of
service would receive $3,750 per month ($125 times 30 years), one
with 25 years of service $3,125 ($125 times 25 years), one with 19
years of service $2,375 ($125 times 19 years) , etc. Instead of
years of service the employer could use months of service or some
other time frame. The idea here is that the longer one has been
employed by the organization, the greater their monthly income at
retirement.
A simple final average pay method bases the monthly
retirement income amount on some pre-determined percentage of the
employee's salary for the last three (or some other number) years
of work. The employer simply sums the employee's annual salary for
the last few years of employment, divides that figure by three to
get the average for the three years and multiplies that amount by
the pre-determined percentage amount. Generally, employers average
the three or five highest salary years out of the last ten years
rather than simply averaging the salary for the last three or five
years. This benefits people who are compensated with a base salary
plus variable additions such as commissions, overtime pay,
compensation for additional or hazzardous work, etc.
In most cases, defined benefit plans calculate the
benefit using one of the above two methods as the base but include
other factors in the calculation as well. However, regardless of
the method used, the result is a fixed monthly amount that the
employer is committed to paying the retiree for the rest of the
retiree's life.
Defined Contribution Plans
Defined contribution plans are plans in which the
employer agrees to contribute a fixed amount to the employee's
pension fund each year in which the employee is employed. The
income that the employee receives during retirement depends upon
how much money the plan accumulated and how much income that
amount can generate. The 401(k) plans offered by many employers in
the private sector and 403(b) plans offered by public and
non-profit employers are common examples of defined contribution
plans.
Under both types of plans, funding of the pension
can be in the form of contributions made by the employer alone or
by contributions from both the employer and employee.
Market Risk
One of the major differences, if not the major
difference, between defined benefit and defined contribution plans
is market risk. Market risk is the risk associated with changes in
the value of the investments in the plan.
In order to grow and have the plan generate
sufficient income to provide retirement income, the money put
aside for retirement during an employee's working years must be
invested in income producing assets. This usually includes
investing in things like stocks, bonds, real estate, etc. However,
as we saw in the recent 2008 market crash, the value of such
assets can fluctuate.
Market Risk and Defined Benefit
Plans
With defined benefit plans the employer assumes the
market risk which can be either good or bad. During periods of
economic growth and rising asset values, the cost of funding
(i.e., contributing money to the plan and investing it to
accumulate funds necessary to pay the pensions when employees
retire) a pension decreases as the rising values of the
investments enables the employer to contribute less out of current
revenues and still build the value of the plan to cover the future
pension obligations.
Even in periods of little or no growth but rising
asset values due to inflation (such as occurred in the 1960s and
1970s in the U.S. due to the government's inflationary fiscal and
monetary policies) employers can benefit because their commitment
is to pay a fixed dollar amount to employees at retirement and not
provide the employee with a fixed purchasing power.
However, when markets go down and asset values
decrease with them, the employer is forced to pump more money into
the plan in order to meet the future obligation to the retirees.
With defined benefit plans retirees continue to
receive the same dollar income each month regardless of market
conditions. When markets decline, employees are not affected but
the employer is hurt because the employer now has to divert more
money from current revenue into the pension plan thereby
increasing its costs at the expense of its profit. When markets
rise, the employer reaps the benefit of the rising values and can
reduce its pension contributions and increase its profits while
the retiree continues to receive the same promised income.
The retirees are not harmed as their income does
not decrease but they also do not receive any benefit (in terms of
their pension income) from the economic growth. When inflation
drives market values up the employer again benefits by being able
to maintain the monthly pension income for the retirees while
paying fewer dollars to do so. The retirees, however, are harmed
because, while the dollar amount of their pension income remains
constant the purchasing power of those dollars decreases thereby
reducing their standard of living.
Market Risk and Defined
Contribution Pension Plans
With defined contribution plans market risk and
reward are reversed as the retirees assume most of the risks and
reap most of the benefits.
When economic growth causes investment values to
increase, the retirees see their wealth and income increase while
employers are unable to adjust their contributions downward.
Similarly, when inflation causes investment values
to rise, employers are again unable to adjust their contributions
while retirees see the dollar value of their pension funds rise.
While inflation induced increases in pension values
and income generated by these rising values doesn't increase the
retirees' spending power (as all prices in the economy are
increasing due to inflation) the inflation induced increases in
their pension values and income offset the rise in prices thereby
allowing their standard of living to remain unchanged.
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