Basic Pension Terminology Explained

There are number of different types of pension options that will help you save for your retirement .Your employer may determine the type of option that works best for you, or you may have the flexibility to elect the type of pension you feel will benefit you most.

General Pension Plan Terms

The main categories are: defined contribution plans and defined benefit plans. Defined contribution plans depend on the money you place into a pension each deposit you make. The amount of money you have in the plan is called vested funds. Once you retire, you will then be paid based on the amount you have contributed.

A defined benefit plan does not depend on the contributions you made. Instead, a formula is used to decide your benefits. This formula usually involves the length of time you worked for the company and your salary, among other factors. All pension plans offer some tax benefits, but the way the IRS handles these benefits depends on the exact way the plan is set up.

Defined Contribution Plan Terms

  • Employee Stock Ownership Plan (ESOP) - Your employer may offer you the chance to purchase stock in the company with a portion of your salary each week, month or year. Upon your retirement, you will receive dividends on the stock based on how much you contributed and how much the stock grew.
  • Profit sharing - Your employer may give you equity in a company if the company is not public. This is called profit sharing, and, after retirement, you will begin to receive a percentage of company profits based on how much you contributed in equity.
  • 401k - Your employer may offer to match contributions into a 401k plan on your behalf. The company 401k administrator will then invest the funds with the hope of growing them. You will be paid based on how much you have invested.

Defined Benefit Plan Terms

  • Cash balance - A cash balance plan allows your employer to contribute funds to your account each year based on your salary or bonus. There will be an account balance when you retire or leave the company, and this balance will be used to determine your benefits from that point forward.
  • Money purchase - A money purchase plan is very similar to a cash balance plan. An employer may contribute up to 25% of an employee's salary each year to this plan. Employers choose how to do this at their discretion. They may contribute funds each pay check or simply give lump sum bonuses.
  • Simplified Employee Pension - Many small businesses prefer this simplified model. The employer contributes funds each year into an account that will be the basis for retirement earnings for all the employees with the company. These plans cost less to administer, and the funds are immediately and 100% vested. Self-employed individuals may use this option to negate the cost of a burdensome plan while still saving for retirement.
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