Saving for Retirement - Pension Plans
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What is a Pension Plan?
A pension plan is an employee benefit wherein the employer makes regular contributions to a pool of money that is set aside to pay retired employees. Some pension plans allow employees to make additional contributions, on top of the contributions made by the employer. Pensions have become relatively rare in the private sector (they’ve been replaced with traditional 401(k) plans, which we discussed in last week’s letter) but remain common for public sector employees. Indeed, according to Investopedia, ~83% of public employees and ~15% of private employees in the U.S. are covered by a pension plan. There are two primary types of pensions: defined-benefit plans and defined-contribution plans.
Defined-Benefit Plan
In a defined-benefit plan, an employee is guaranteed to receive a pre-specified monthly payment after retirement for life, regardless of how the underlying investment pool is performing. Payment amounts are typically determined based on earnings and years of service provided by the employee. In cases where the assets in the pension plan account are not sufficient to pay the benefits that are due, the company is liable for the remainder of the payment.
Defined-Contribution Plan
In a defined contribution plan, the employer agrees to make a specified contribution for each employee covered by the plan and the employer’s contribution may often be matched by the employees. The final benefit received by the employee depends on the plan's investment performance rather than guaranteed monthly payments (as is the case in defined-benefit plans). The company’s liability for distributing funds ends when the total contributions are expended. Compared to the defined-benefit plan, the defined-contribution plan is much less expensive for a company to sponsor, and the long-term costs are relatively easier to estimate. The 401(k) - which we covered last week - is actually a version of a defined-contribution plan.
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Is your Pension Plan taxable?
Many pension plans fall under a similar tax status as a Traditional 401(k). Contributions that employees make to the plan come from “pre-tax” dollars, meaning that they are taken out of the employee's gross income. This reduces the employee's taxable income for the year in which the contribution was made, however the funds are taxed when the employee begins withdrawals in retirement. While the funds are in the retirement account, they are allowed to grow at a tax-deferred rate, meaning no tax is due on the funds as long as they remain in the account. This tax structure is common for both defined-benefit and defined-contribution plans.
Collecting money from your Pension
With a defined-benefit plan, employees typically have two options when it comes to withdrawals: periodic payments (typically paid out monthly) for the rest of their life, or a lump-sum. It should be noted, however, that some plans allow participants to do both - they can take some of the money in a lump sum and receive the rest via periodic payments.
Periodic (again, often monthly) annuity payments are typically offered as a choice of a single-life annuity for the retiree-only for life, or as a joint and survivor annuity for the retiree and his/her spouse. In the case of a single life annuity, if the employee dies, the pension payout stops, but a large tax-free death benefit could be paid out to a surviving spouse. Annuities usually pay at a fixed rate and may or may not include adjustments to protect retirees from inflation. One potential risk involved in periodic payouts is that the pension plan may run out of money - however, please note that there are often protection plans in place if this happens.
Nevertheless, one way to avoid this risk is to receive your pension as a lump sum, taking it all at once. Another potential benefit of the lump sum withdrawal is that the retiree can re-invest the money. Additionally, if you receive a lump sum and die, you can pass the funds along as part of your estate. It’s important to note, however, that with a lump sum withdrawal, you remove a guaranteed lifetime income, meaning that it will be up to the retiree to make the money last. Additionally, unless the lump sum is rolled into an IRA or other tax-sheltered account, the entire amount will be immediately taxed (potentially pushing you into a higher tax bracket).
It’s never too early to start saving for retirement
As we said in our introduction to this series, if you take one thing from this series on retirement investing, let it be this: it’s never too early to start saving for retirement - it may seem like a lifetime away, but time will go fast and your future self will be glad you started saving early! As always, we hope that you will find this series useful and please don’t hesitate to reach out with comments or questions about the content! Here is a running list of the articles included in this series:
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Finish out the week strong!
Dan & Brandon
Disclosure: The article was written by Daniel Kuhman and Brandon Keys, and it expresses the author's own opinions. The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock, asset, or cryptocurrency. Brandon and Daniel are not financial advisors. We encourage all readers to do further research and do your own due diligence before making any investments.