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A retirement plan is an arrangement to provide people with an income, or pension, during retirement, when they are no longer earning a steady income from employment. Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Retirement plans are more commonly known as pension schemes in the UK and Ireland and superannuation plans in Australia.
Types of retirement plans
Retirement plans may be classified as defined benefit or defined contribution according to how the benefits are determined. A defined benefit plan guarantees a certain payout at retirement, according to a fixed formula which usually depends on the member's salary and the number of years' membership in the plan. A defined contribution plan will provide a payout at retirement that is dependent upon the amount of money contributed and the performance of the investment vehicles utilized.
Some types of retirement plans, such as cash balance plans, combine features of both defined benefit and defined contribution plans. They are often referred to as hybrid plans.
Defined contribution plans
In a defined contribution plan, contributions are paid into an individual account for each member. The contributions are invested, for example in the stock market, and the returns on the investment (which may be positive or negative) are credited to the individual's account. On retirement, the member's account is used to provide retirement benefits, often through the purchase of an annuity which provides a regular income. Defined contribution plans have become more widespread all over the world in recent years, and are now the dominant form of plan in the private sector in many countries. For example, the number of DB plans in the US has been steadily declining, as more and more employers see the large pension contributions as a large expense that they can avoid by disbanding the plan and instead offering a defined contribution plan.
Examples of defined contribution plans in the USA include Individual Retirement Accounts (IRAs) and 401(k) plans. In such plans, the employee is responsible, to one degree or another, for selecting the types of investments toward which the funds in the retirement plan are allocated. This may range from choosing one of a small number of pre-determined mutual funds to selecting individual stocks or other securities. Most self-directed retirement plans are characterized by certain tax advantages, and some provide for a portion of the employee's contributions to be matched by the employer. In exchange, the funds in such plans may not be withdrawn by the investor prior to reaching a certain age.
Defined benefit plans
Traditionally, retirement plans have been administered by institutions which exist specifically for that purpose, by large businesses, or, for government workers, by the government itself. A traditional form of defined benefit plan is the final salary plan, under which the pension paid is equal to the number of years worked, multiplied by the member's salary at retirement, multiplied by a factor known as the accrual rate.
The final accrued amount is available as a monthly pension or a lump sum.
In addition, many countries offer state-sponsored retirement benefits, beyond those provided by employers, which are funded by payroll or other taxes. In the U.S., this is one role of Social Security.
Defined benefit plans may be either funded or unfunded. In a funded plan, contributions from the employer, and sometimes also from plan members, are invested in a fund towards meeting the benefits. The future returns on the investments, and the future benefits to be paid, are not known in advance, so there is no guarantee that a given level of contributions will be enough to meet the benefits. Typically, the contributions to be paid are regularly reviewed in a valuation of the plan's assets and liabilities, carried out by an actuary. In many countries, such as the USA, the UK and Australia, most private defined benefit plans are funded, because governments there provide tax incentives to funded plans.
In an unfunded plan, no funds are set aside. The benefits to be paid are met immediately by contributions to the plan. Most government run retirement plans, such as the social security system in the USA and most European countries, are unfunded, with benefits being paid directly out of current taxes and social security contributions. In some countries, such as Germany, Austria and Sweden, company run retirement plans are often unfunded.
A cash balance plan is a defined benefit plan made by the employer, with the help (some critics say the connivance) of consulting actuaries (like Kwasha Lipton, whom it is said created the cash balance plan) to appear as if they were defined contribution plans. They have notional balances in hypothetical accounts where, typically, each year the plan administrator will contribute an amount equal to a certain percentage of each participant's salary; a second contribution, called interest credit, is made as well. These are not actual contributions and further discussion is beyond the scope of this entry suffice it to say that there is currently much controversy.
Target Benefit plans are defined contribution plans made to match (or look like) defined benefit plans. This would only work if all actuarial assumptions are actually realized.
Contrasting types of retirement plans
Advocates of defined contribution plans point out that each employee has the ability to tailor the investment portfolio to his or her individual needs and financial situation, including the choice of how much to contribute, if anything at all. However, others state that these apparent advantages could also hinder some workers who might not possess the financial savvy to choose the correct investment vehicles or have the discipline to voluntarily contribute money to retirement accounts. This debate parallels the discussion currently going on in the U.S., where many Republican leaders favor transforming the Social Security system, at least in part, to a self-directed investment plan.
- UK Pension Provision
- Superannuation in Australia
- Provident Fund
- Individual Pension Plan (IPP)
- Individual Retirement Account (IRA)
- Public Employee Pension Plans (United States)
- Retirement plans in the United States
- Roth 401(k)
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