Pensions - Structure and the PBGC

Part 1: Structure and the PBGC

A 401(k) retirement savings plan is structured as a defined contribution plan. The plan defines the amount of money that you can put into it and how much your employer will match, if any. You can usually choose relatively safe, fixed-rate investments for your funds, or you can opt for somewhat riskier alternatives.

In much the same manner, a pension which is structured as a defined benefit plan provides a predictable, secure amount of money to you for the rest of your life, beginning at a specified age. Normally, the employer is responsible for making the required contributions to the plan so that it’s funded sufficiently to make the appropriate benefits available when required. As such, the employer decides where the funds will be invested. With a defined benefit pension, the longer you remain with the company, the larger your pension will be.

You’ve no doubt recently heard or read about numerous large corporations whose pension plans were underfunded. The federal government has an agency in place, called the Pension Benefit Guaranty Corporation (PBGC), which is charged with insuring corporate pension plans. If a corporate plan defaults, the PBGC will pick up the appropriate payments, subject to certain limits; in other words, larger pensions may not necessarily be protected. You can probably understand why when you realize that the PBGC is currently operating with a $23 billion deficit.

Although the PBGC attempts to encourage companies to offer defined plans so that their employees can know and plan for the amount of money they’ll receive upon retirement, the trend is moving away from defined benefit plans. There has been a significant drop in the number of defined plans that the agency insures, from 95,000 plans in 1980 to around 40,000 today. Also, in the last thirty years, the PBGC has been forced to take over more than 3,400 defaulted pension plans.

As a very prudent hedge against such alarming statistics, some workers are taking more direct responsibility for their financial planning and the funding of their retirement. But while a number of people have millions of dollars in their accounts, the average amount of money in a 401(k) is $29,000 while the median level is only about $10,000. That’s not likely to help much if it’s the only money you’ve saved for retirement and don’t have a pension. To put it plainly, most employees simply aren’t saving enough.

Also, many people are not aware of just how their pensions are calculated. With most pensions, the benefit depends upon such factors as the employee’s earnings, length of employment, the age when he or she begins collecting benefits, and the formula which the plan utilizes. For instance, the formula might use an average of your pay in the final three- to five years of employment. With the current climate surrounding the state of corporate pension plans, it behooves you to understand exactly how your pension is calculated to ensure that you’ll receive all of the benefits due you.

Some companies now offer cash balance pensions. With this type of structure, the employer typically puts five percent of the employee’s pay into the individual’s pension account each year. The employer also pays interest on the account’s balance. When the employee leaves, the funds in the account may be rolled into an IRA or a new employer’s retirement plan.

In Part 2 of this series, we’ll look at pension vesting and your distribution options.

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