Pension plans offer investors great advantages. The plans collect funds, invest them, and administer the payments to participants when they retire. They almost always possess tax advantages. Pension funds fall into two distinct types: defined benefit (DB) arrangements, those that promise participants specific benefits in retirement, and defined contribution (DC) arrangements, those that make no such promise but allow participants advantageous ways to accumulate funds and invest them for retirement. Within these two basic structures, funds can vary greatly.
Because there is much to say, I will use this post and the next to examine the topic. In this post I take up DB plans and the generalities of DC plans. The next post will go through the complexities of DC plans, which will include 401(k) plans and IRAs.
Defined Benefit Plans
DB plans are what most people think of as pensions. Social Security is a DB plan. In a DB, an employer or government entity promises to pay retirees a certain amount until they die. Plans might include cost-of-living escalators, and they might also include medical and death benefits and/or provisions for continued payments to a surviving spouse or partner. Provisions vary from plan to plan.
The “sponsor,” who sets up the plan, pools employee contributions into a fund, and invests those monies prudently to fulfill the plan’s promises. Sometimes the sponsor makes contributions from its own resources, sometimes it collects them from participants, and sometimes it relies on contributions from both sources. The administration and investment decisions are entirely the sponsor’s — participants have no say, because it is the sponsor, not the participants who has the obligation to pay. If the fund falls short, the sponsor must make good its obligations. If the sponsor is a corporation, that burden then falls on the shareholders. If the sponsor is a government entity, the burden falls on the taxpayer.
All these plans are exempt from investment taxes, though participants pay income taxes on the distributions made when they have retired.
Here are the three best-known examples of defined benefit plans:
- Social Securityis funded from the payroll taxes paid equally by employers and employees. Its payments include an escalator tied to the rate of inflation and benefits paid to surviving spouses, referred to as “spousal benefits.” To some extent Social Security is interwoven with disability and Medicare, both of which are supported from the same sources that fund Social Security. When these funds are invested, it is solely in U.S. Treasury bonds.
- State and Local Government Plans include a variety of retirement plans for government employees. All are funded in varying degrees by the sponsoring government entity –– that is, by taxpayers. Some plans also rely on contributions from participants during their employment. Many have escalators to accommodate rising living costs, and many offer medical benefits, though the specifics vary greatly. All count on investments in stocks, bonds, and other assets to sustain the funds necessary to meet the plan’s obligations.
- Corporate Plans are usually offered by larger, well-established companies. All get most of their funding from the corporate sponsor –– that is, from the shareholders. Many also rely on contributions from employee-participants. Most include cost-of-living escalators and survivor benefits. Here too, some offer medical benefits. All invest in stocks, bonds, and other assets to sustain and grow the funds.
Defined Contribution Plans
Though these so-called DC plans make none of the promises of DB plans, they have one great appeal over the DB variety: participants in DC plans own the assets accumulated with the contributions made in their name, and they can direct them as they see fit. All DC plans rely on fixed contributions made by the sponsor on behalf of the participants. The firms and government entities that establish them also make contributions on behalf of individual participants. All also accept additional contributions from individual participants. Some firms, states, and local governments rely on defined contribution plans to supplement their defined benefit offerings. Some only offer DC plans.
Because the DC assets belong to the individual participant, they follow the employee into the next job, into retirement, and should participants die before the participant’s assets are exhausted, to their designated beneficiaries. In financial jargon, these assets are said to be portable. The funds available for retirement depend entirely on the contributions and their relative investment success over the years. More on these varied structures in the next post, including their tax advantages.