A pension plan is typically a kind of retirement plan agreement entered into between an employee and his employer whereby the latter puts aside/contributes some money for a pool of funds meant for the employee’s future use. The pool of funds is invested on behalf of the employee, enabling him to start getting money from it, following his retirement. Pension plans are generally tax-exempt. If the employee wishes, he may also contribute a portion of his income towards the retirement amount.
Pension Plans – Two Key Types
Pension plans are chiefly of two categories:
1) Defined-benefit plan – In this plan, the employer assures that the employee will get a fixed monthly sum as benefit upon retirement irrespective of the underlying investment pool’s performance. The sum is predetermined by way of a formula that considers factors such as tenure of employment, the employee’s salary history and age. One of the methods adopted to decide on the fixed monthly income is a dollars times service calculation. Here the employee’s number of years of service is multiplied by some dollar amount. Example: tenure of service multiplied by $125.
2) Defined-contribution plan – In this plan, the employer makes predetermined regular contributions for the employee’s benefit. The employee may also contribute. While the employer’s (and the employee’s, wherever applicable) contributions are guaranteed, the amount that the employee would get in terms of future benefits is not. This is because in this plan, the future benefits vary depending on the investment pool’s performance. One example of a defined contribution plan is the 401(k) plans which many private sector employers. In this plan, an employee contributes from his paycheck either prior to or after tax on the basis of what options the plan offers.
Pension plans are a popularly sought after employee benefit along with health insurance and paid vacations.