Pension

This article is about the retirement income arrangement. For the type of lodging, see Pension (lodging). For the mortgage repayment scheme, see Mortgage loan.

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In general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment.^[1] Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.

The terms retirement plan or superannuation refer to a pension granted upon retirement.^[2] Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Called retirement plans in the United States, they are commonly known as pension schemes in the United Kingdom and Ireland and superannuation plans or super^[3] in Australia and New Zealand. Retirement pensions are typically in the form of a guaranteed life annuity, thus insuring against the risk of longevity.

A pension created by an employer for the benefit of an employee is commonly referred to as an occupational or employer pension. Labor unions, the government, or other organizations may also fund pensions. Occupational pensions are a form of deferred compensation, usually advantageous to employee and employer for tax reasons. Many pensions also contain an additional insurance aspect, since they often will pay benefits to survivors or disabled beneficiaries. Other vehicles (certain lottery payouts, for example, or an annuity) may provide a similar stream of payments.

The common use of the term pension is to describe the payments a person receives upon retirement, usually under pre-determined legal and/or contractual terms. A recipient of a retirement pension is known as a pensioner or retiree.

Types of pensions

Employment-based pensions (retirement plans)

A retirement plan is an arrangement to provide people with an income during retirement when they are no longer earning a steady income from employment. Often retirement plans require both the employer and employee to contribute money to a fund during their employment in order to receive defined benefits upon retirement. It is a tax deferred savings vehicle that allows for the tax-free accumulation of a fund for later use as a retirement income. Funding can be provided in other ways, such as from labor unions, government agencies, or self-funded schemes. Pension plans are therefore a form of "deferred compensation". A SSAS is a type of employment-based Pension in the UK.

Social and state pensions

Many countries have created funds for their citizens and residents to provide income when they retire (or in some cases become disabled). Typically this requires payments throughout the citizen's working life in order to qualify for benefits later on. A basic state pension is a "contribution based" benefit, and depends on an individual's contribution history. For examples, see National Insurance in the UK, or Social Security in the USA. Many countries have also put in place a "social pension". These are regular, tax-funded non-contributory cash transfers paid to older people. Over 80 countries have social pensions.[4] Examples are the Old Age Grant in South Africa and the Universal Superannuation scheme in New Zealand.

Disability pensions

Some pension plans will provide for members in the event they suffer a disability. This may take the form of early entry into a retirement plan for a disabled member below the normal retirement age.

Benefits

Retirement plans may be classified as defined benefit or defined contribution according to how the benefits are determined.^[4] 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. Such plan designs have become increasingly popular in the US since the 1990s. Examples include Cash Balance and Pension Equity plans.

Defined benefit plans

Main article: Defined benefit pension plan

A traditional defined benefit (DB) plan is a plan in which the benefit on retirement is determined by a set formula, rather than depending on investment returns. In the US, 26 U.S.C. § 414(j) specifies a defined benefit plan to be any pension plan that is not a defined contribution plan (see below) where a defined contribution plan is any plan with individual accounts. A traditional pension plan that defines a benefit for an employee upon that employee's retirement is a defined benefit plan.

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, but usually monthly.

The benefit in a defined benefit pension plan is determined by a formula that can incorporate the employee's pay, years of employment, age at retirement, and other factors. A simple example is a Dollars Times Service plan design that provides a certain amount per month based on the time an employee works for a company. For example, a plan offering $100 a month per year of service would provide $3,000 per month to a retiree with 30 years of service. While this type of plan is popular among unionized workers, Final Average Pay (FAP) remains the most common type of defined benefit plan offered in the United States. In FAP plans, the average salary over the final years of an employee's career determines the benefit amount.

Averaging salary over a number of years means that the calculation is averaging different dollars. For example, if salary is averaged over five years, and retirement is in 2009, then salary in 2004 dollars is averaged with salary in 2005 dollars, etc., with 2004 dollars being worth more than the dollars of succeeding years. The pension is then paid in first year of retirement dollars, in this example 2009 dollars, with the lowest value of any dollars in the calculation. Thus inflation in the salary averaging years has a considerable impact on purchasing power and cost, both being reduced equally by inflation

This effect of inflation can be eliminated by converting salaries in the averaging years to first year of retirement dollars, and then averaging.

In the United Kingdom, benefits are typically indexed for inflation (known as Retail Prices Index (RPI)) as required by law for registered pension plans.^[5] Inflation during an employee's retirement affects the purchasing power of the pension; the higher the inflation rate, the lower the purchasing power of a fixed annual pension. This effect can be mitigated by providing annual increases to the pension at the rate of inflation (usually capped, for instance at 5% in any given year). This method is advantageous for the employee since it stabilizes the purchasing power of pensions to some extent.

If the pension plan allows for early retirement, payments are often reduced to recognize that the retirees will receive the payouts for longer periods of time. In the United States, under the Employee Retirement Income Security Act of 1974, any reduction factor less than or equal to the actuarial early retirement reduction factor is acceptable.^[6]

Many DB plans include early retirement provisions to encourage employees to retire early, before the attainment of normal retirement age (usually age 65). Companies would rather hire younger employees at lower wages. Some of those provisions come in the form of additional temporary or supplemental benefits, which are payable to a certain age, usually before attaining normal retirement age.^[7]

Funding

Defined benefit plans may be either funded or unfunded.

In an unfunded defined benefit pension, no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid. Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly from current workers' contributions and taxes. This method of financing is known as Pay-as-you-go (PAYGO or PAYG).^[8] The social security systems of many European countries are unfunded^{[citation needed]}, having benefits paid directly out of current taxes and social security contributions, although several countries have hybrid systems which are partially funded. Spain set up the Social Security Reserve Fund and France set up the Pensions Reserve Fund; in Canada the wage-based retirement plan (CPP) is funded, with assets managed by the CPP Investment Board while the U.S. Social Security system is funded by investment in special U.S. Treasury Bonds.

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 to ensure that the pension fund will meet future payment obligations. This means that in a defined benefit pension, investment risk and investment rewards are typically assumed by the sponsor/employer and not by the individual. If a plan is not well-funded, the plan sponsor may not have the financial resources to continue funding the plan. In many countries, such as the USA, the UK and Australia, most private defined benefit plans are funded^{[citation needed]}, because governments there provide tax incentives to funded plans (in Australia they are mandatory). In the United States, non-church-based private employers must pay an insurance-type premium to the Pension Benefit Guaranty Corporation, a government agency whose role is to encourage the continuation and maintenance of voluntary private pension plans and provide timely and uninterrupted payment of pension benefits.

Criticisms

Traditional defined benefit plan designs (because of their typically flat accrual rate and the decreasing time for interest discounting as people get closer to retirement age) tend to exhibit a J-shaped accrual pattern of benefits, where the present value of benefits grows quite slowly early in an employee's career and accelerates significantly in mid-career: in other words it costs more to fund the pension for older employees than for younger ones (an "age bias"). Defined benefit pensions tend to be less portable than defined contribution plans, even if the plan allows a lump sum cash benefit at termination. Most plans, however, pay their benefits as an annuity, so retirees do not bear the risk of low investment returns on contributions or of outliving their retirement income. The open-ended nature of these risks to the employer is the reason given by many employers for switching from defined benefit to defined contribution plans over recent years. The risks to the employer can sometimes be mitigated by discretionary elements in the benefit structure, for instance in the rate of increase granted on accrued pensions, both before and after retirement.

The age bias, reduced portability and open ended risk make defined benefit plans better suited to large employers with less mobile workforces, such as the public sector (which has open-ended support from taxpayers). This coupled with a lack of foresight on the employers part means a large proportion of the workforce are kept in the dark over future investment schemes.

Defined benefit plans are sometimes criticized as being paternalistic as they enable employers or plan trustees to make decisions about the type of benefits and family structures and lifestyles of their employees. However they are typically more valuable than defined contribution plans in most circumstances and for most employees (mainly because the employer tends to pay higher contributions than under defined contribution plans), so such criticism is rarely harsh.

The "cost" of a defined benefit plan is not easily calculated, and requires an actuary or actuarial software. However, even with the best of tools, the cost of a defined benefit plan will always be an estimate based on economic and financial assumptions. These assumptions include the average retirement age and lifespan of the employees, the returns to be earned by the pension plan's investments and any additional taxes or levies, such as those required by the Pension Benefit Guaranty Corporation in the U.S. So, for this arrangement, the benefit is relatively secure but the contribution is uncertain even when estimated by a professional.

Examples

Many countries offer state-sponsored retirement benefits, beyond those provided by employers, which are funded by payroll or other taxes. The United States Social Security system is similar to a defined benefit pension arrangement, albeit one that is constructed differently than a pension offered by a private employer.

Individuals that have worked in the UK and have paid certain levels of national insurance deductions can expect an income from the state pension scheme after their normal retirement. The state pension is currently divided into two parts: the basic state pension, State Second [tier] Pension scheme called S2P. Individuals will qualify for the basic state pension if they have completed sufficient years contribution to their national insurance record. The S2P pension scheme is earnings related and depends on earnings in each year as to how much an individual can expect to receive. It is possible for an individual to forgo the S2P payment from the state, in lieu of a payment made to an appropriate pension scheme of their choice, during their working life. For more details see UK pension provision.

Defined contribution plans

Main article: Defined contribution plan

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, sometimes through the purchase of an annuity which then provides a regular income. Defined contribution plans have become 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 defined benefit plans in the US has been steadily declining, as more and more employers see pension contributions as a large expense avoidable by disbanding the defined benefit plan and instead offering a defined contribution plan.

Money contributed can either be from employee salary deferral or from employer contributions. The portability of defined contribution pensions is legally no different from the portability of defined benefit plans. However, because of the cost of administration and ease of determining the plan sponsor's liability for defined contribution plans (you do not need to pay an actuary to calculate the lump sum equivalent that you do for defined benefit plans) in practice, defined contribution plans have become generally portable.

In a defined contribution plan, investment risk and investment rewards are assumed by each individual/employee/retiree and not by the sponsor/employer. In addition, participants do not necessarily purchase annuities with their savings upon retirement, and bear the risk of outliving their assets. (In the United Kingdom, for instance, it is a legal requirement to use the bulk of the fund to purchase an annuity.)

The "cost" of a defined contribution plan is readily calculated, but the benefit from a defined contribution plan depends upon the account balance at the time an employee is looking to use the assets. So, for this arrangement, the contribution is known but the benefit is unknown (until calculated).

Despite the fact that the participant in a defined contribution plan typically has control over investment decisions, the plan sponsor retains a significant degree of fiduciary responsibility over investment of plan assets, including the selection of investment options and administrative providers.

Examples

In the United States, the legal definition of a defined contribution plan is a plan providing for an individual account for each participant, and for benefits based solely on the amount contributed to the account, plus or minus income, gains, expenses and losses allocated to the account (see 26 U.S.C. § 414(i)). Examples of defined contribution plans in the United States 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—typically the year the employee reaches 59.5 years old-- (with a small number of exceptions) without incurring a substantial penalty.

In the US, defined contribution plans are subject to IRS limits on how much can be contributed, known as the section 415 limit. In 2009, the total deferral amount, including employee contribution plus employer contribution, was limited to $49,000 or 100% of compensation, whichever is less. The employee-only limit in 2009 is $16,500 with a $5,500 catch-up. These numbers may increase each year and are indexed to compensate for the effects of inflation.

Hybrid and cash balance plans

Hybrid plan designs combine the features of defined benefit and defined contribution plan designs.

A cash balance plan is a defined benefit plan made by the employer, with the help of consulting actuaries (like Kwasha Lipton, who 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. In general, they are usually treated as defined benefit plans for tax, accounting and regulatory purposes. As with defined benefit plans, investment risk in hybrid designs is largely borne by the plan sponsor. As with defined contribution designs, plan benefits are expressed in the terms of a notional account balance, and are usually paid as cash balances upon termination of employment. These features make them more portable than traditional defined benefit plans and perhaps more attractive to a more highly mobile workforce.

Target benefit plans are defined contribution plans made to match (or resemble) defined benefit plans.

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.

Financing

There are various ways in which a pension may be financed.

Defined contribution pensions, by definition, are funded, as the "guarantee" made to employees is that specified (defined) contributions will be made during an individual's working life.

History

Widows' funds were among the first pension type arrangement to appear, for example Duke Ernest the Pious of Gotha founded a widows' fund for clergy in 1645 and another for teachers in 1662.^[9] 'Various schemes of provision for ministers' widows were then established throughout Europe at about the start of the eighteenth century, some based on a single premium others based on yearly premiums to be distributed as benefits in the same year.'^[10]

Germany

As part of Otto von Bismarck's social legislation, the Old Age and Disability Insurance Bill was enacted in 1889. The Old Age Pension program, financed by a tax on workers, was originally designed to provide a pension annuity for workers who reached the age of 70 years, though this was lowered to 65 years in 1916. It is sometimes claimed that at the time life expectancy for the average Prussian was 45 years; in fact this figure ignores the very high infant mortality and high maternal death rate from childbirth of this era. In fact, an adult entering into insurance under the scheme would on average live to 70 years of age, a figure used in the actuarial assumptions included in the legislation.

United States

Public pensions got their start with various 'promises', informal and legislated, made to veterans of the Revolutionary War and, more extensively, the Civil War. They were expanded greatly, and began to be offered by a number of state and local governments during the early Progressive Era in the late nineteenth century.^{[citation needed]}

Federal civilian pensions were offered under the Civil Service Retirement System (CSRS), formed in 1920. CSRS provided retirement, disability and survivor benefits for most civilian employees in the US Federal government, until the creation of a new Federal agency, the Federal Employees Retirement System (FERS), in 1987.

Pension plans became popular in the United States during World War II, when wage freezes prohibited outright increases in workers' pay. The defined benefit plan had been the most popular and common type of retirement plan in the United States through the 1980s; since that time, defined contribution plans have become the more common type of retirement plan in the United States and many other western countries.

Current challenges

A growing challenge for many nations is population ageing. As birth rates drop and life expectancy increases an ever-larger portion of the population is elderly. This leaves fewer workers for each retired person. In almost all developed countries this means that government and public sector pensions could collapse their economies unless pension systems are reformed or taxes are increased. One method of reforming the pension system is to increase the retirement age. Two exceptions are Australia and Canada, where the pension system is forecast to be solvent for the foreseeable future. In Canada, for instance, the annual payments were increased by some 70% in 1998 to achieve this. These two nations also have an advantage from their relative openness to immigration. However, their populations are not growing as fast as the U.S., which supplements a high immigration rate with one of the highest birthrates among Western countries. Thus, the population in the U.S. is not aging to the extent as those in Europe, Australia, or Canada.

Another growing challenge is the recent trend of states and businesses in the United States purposely under-funding their pension schemes in order to push the costs onto the federal government. For example, in 2009, the majority of states have unfunded pension liabilities exceeding all reported state debt. Bradley Belt, former executive director of the PBGC (the Pension Benefit Guaranty Corporation, the federal agency that insures private-sector defined-benefit pension plans in the event of bankrupment), testified before a congressional hearing in October 2004, “I am particularly concerned with the temptation, and indeed, growing tendency, to use the pension insurance fund as a means to obtain an interest-free and risk-free loan to enable companies to restructure. Unfortunately, the current calculation appears to be that shifting pension liabilities onto other premium payers or potentially taxpayers is the path of least resistance rather than a last resort.”

Challenges have further been increased by the credit crunch. Total funding of the nation's 100 largest corporate pension plans fell by $303bn in 2008, going from a $86bn surplus at the end of 2007 to a $217bn deficit at the end of 2008.^[11]

Pensions by country

General articles on both public and private pension funds by country:

• Pensions in Canada
• Pensions in Chile
• Pensions in India
• Pensions in Norway
• Pensions in Pakistan
• Pensions in the United States
• Pensions in the United Kingdom

Famous examples of pension systems

Some of the listed systems might also be considered social insurance.

• Argentina:
  • Administración Nacional de la Seguridad Social
• Australia:
  • Superannuation in Australia - Private occupational pensions
  • Social Security - Public pensions
• Canada:
  • Canada Pension Plan
  • Old Age Security
  • Quebec Pension Plan
  • Registered Retirement Savings Plan
  • Saskatchewan Pension Plan
• Hong Kong - Mandatory Provident Fund
• Finland - Kansaneläkelaitos
• India - Employees' Provident Fund Organisation of India
• Japan - National Pension
• Malaysia - Employees Provident Fund
• Mexico - Mexico Pension Plan
• Netherlands - Algemene Ouderdoms Wet
• New Zealand - KiwiSaver
• Singapore - Central Provident Fund
• Sweden - Social Security
• United Kingdom:
  • UK pension provision (generally)
  • Self-invested personal pensions
• United States:
  • Public employee pensions
  • Retirement plans in the United States
  • Social Security

Market structure

The market for pension fund investments is still centered around the U.K.and U.S. economies.^{[citation needed]} Japan and the EU are conspicuous by absence.^{[citation needed]} As of 2005 the U.S. was the largest market for pension fund investments followed by the UK.^{[citation needed]}

Pension reforms have gained pace worldwide in recent years and funded arrangements are likely to play an increasingly important role in delivering retirement income security and also affect securities markets in future years.

Obtaining survey data on pensions

Numerous worldwide health, aging and retirement surveys contain questions pertaining to pensions. The Meta Data Repository - created by the non-profit RAND Corporation and sponsored by the National Institute on Aging at the National Institutes of Health - provides access to meta data for these questions as well as links to obtain respondent data from the originating surveys.

See also

• Elderly care
• Financial advisor and Fee-only financial advisor
• Generational accounting
• Pensions crisis
• Pension system
• Public debt

Specific:

• Roth 401(k)
• Bankruptcy code
• Individual Pension Plan (IPP)
• Universities Superannuation Scheme
• Provident Fund
• Ham and Eggs Movement, California pension proposal of the 1930s-40s

Notes

1. ^ Princeton WordNet, http://wordnetweb.princeton.edu/perl/webwn?s=pension, viewed 24 December 2008
2. ^ Princeton WordNet, http://wordnetweb.princeton.edu/perl/webwn?s=superannuation, viewed 24 December 2008
3. ^ "Industry SuperFunds - Home". Industrysuper.com. http://www.industrysuper.com/. Retrieved 2010-09-17. 
4. ^ "Private Pensions/Les pensions privées" (PDF). http://www.oecd.org/dataoecd/0/49/38356329.pdf. Retrieved 2010-09-17. 
5. ^ "The Pensions Advisory Service". The Pensions Advisory Service. http://www.pensionsadvisoryservice.org.uk/Pension_Rights/Pension_Increases/. Retrieved 2010-09-17. 
6. ^ Early Retirement Provisions in Defined Benefit Pension Plans. Ann C. Foster http://www.bls.gov/opub/cwc/archive/winter1996art3.pdf
7. ^ Qualified Domestic Relations Order Handbook By Gary A. Shulman p.199-200 Published by: Aspen Publishers Online, 1999 ISBN 0735506655, ISBN 9780735506657
8. ^ "Unfunded Pension Plans" OECD Glossary of Statistical Terms . Retrieved 26 January 2009.
9. ^ Haberman, Steven (1995). History of Actuarial Science, vol. 1. London: William Pickering. pp. xlviii. ISBN 1851961607. http://www.worldcat.org/oclc/468359649. 
10. ^ Hald, A. (1990). A History of Probability and Statistics and Their Applications Before 1750. John Wiley and Sons. ISBN 9780471502302. http://www.worldcat.org/oclc/19629739. 
11. ^ Largest U.S. pension plans' assets fall $217 billion short, http://www.usatoday.com/money/perfi/retirement/2009-03-11-pension-plan-assets-short_N.htm, USA Today, citing a report by Watson Wyatt, 10 March 2009.

References

• "Doing it Offshore" - an independent guide to pension planning offshore
• The Canadian Museum of Civilisation - The History of Canada's Public Pensions
• Pension Benefit Guaranty Corporation (PBGC) - A United States government organisation
• A Global Perspective on Aging and Pensions, Allianz Knowledge, February 2008
• Administration on Aging (Pension Counseling ) - A United States government organisation
• Pensions and Capital Stewardship Project at the Labour and Worklife Program, Harvard Law School - A United States' organisation.
• "Actuarially Speaking: A Plain Language Summary of Actuarial Methods and Practices for Public Employee Pension and Other Post-Employment Benefits," from the California Research Bureau (CRB) at the California State Library
• Creating a Retirement Plan Articles on MSN Money
• Provisions on pensions for migrant workers within the European Union
• Is your pension secure?, Consumer Reports
• How to plan for and decide on a pension impartial advice from BBC raw
• What is a pension fund