Definition
A pension plan is a type of retirement plan where an employer sets aside funds for their employee’s future retirement benefits. The amount set aside is often based on the employee’s salary and years of service. Once the employee retires, they start receiving regular payments from this plan.
Key Takeaways
- A Pension Plan is a type of retirement plan where an employer makes contributions towards a pool of funds set aside for an employee’s future benefit. The pool of funds is invested on the employee’s behalf, and the earnings on the investments generate income to the worker upon retirement.
- There are two main types of pension plans: Defined Benefit Plan and Defined Contribution Plan. In a Defined Benefit Plan, the employer guarantees a specified monthly benefit on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service, and age. In a Defined Contribution Plan, the employee contributes a defined amount into their pension fund, but the final amount they receive depends on the performance of the investment.
- Pension plans provide financial security and stability during retirement when the income is reduced. They are often supplemented by Social Security and individual savings. However, they put a significant financial obligation on the employing companies. A company’s failure to meet its pension benefits commitments can lead to severe financial problems, even bankruptcy.
Importance
A pension plan is a crucial finance term because it represents a type of retirement plan often linked to an employer, where an employee contributes a portion of their wages for long-term savings.
The employer may also often match a certain percentage of worker contributions.
This plan provides a secure financial future by giving a steady income stream during retirement.
Its importance is multifaceted: it allows individuals to maintain their lifestyle after retirement, reduces their dependence on others, and can offer tax benefits during the contribution phase.
Therefore, having a pension plan serves as an essential tool for financial planning and ensures economic stability post-retirement.
Explanation
The purpose of a Pension Plan is to provide an individual with financial security upon retirement. It acts as a type of savings account where an employer or an employee can contribute a certain amount consistently during the employment tenure that will be paid out as a regular income after retirement.
This serves to replace the steady income that a person used to earn when they were employed, providing financial stability and the ability to maintain a certain standard of living during retirement. A Pension Plan is primarily used to fund the retirement years of an individual, often acting as their primary, if not their only, source of income after they stop working.
Not only does it ensure a steady cash flow but it can also cover medical expenses and offer benefits to survivors in case of the plan holder’s death. For companies, providing a Pension Plan can act as an incentive for attracting and retaining employees by playing a contributing role towards their long-term financial stability.
Examples of Pension Plan
“Teachers’ Retirement System (TRS)”: TRS is a retirement system for public school teachers in different states in the U.S like New York and Texas. The teachers contribute a portion to their salary to the plan during their working years, and upon retirement, they receive a steady income that supports their living expenses.
“Government Service Insurance System (GSIS)”: GSIS is a pension plan for all employees of the Philippine government. It aims to provide and administer the retirement, disability, life insurance and other benefits for its members, ensuring their financial security during their retirement.
“General Motors Pension Plan”: General Motors, the automobile manufacturing company, offers pension plans for its employees (including those of its subsidiaries). Once eligible employees reach their retirement age, they can benefit from the retirement plan, which offers fixed monthly payments based on their salary and length of service.
Pension Plan FAQ
What is a Pension Plan?
A pension plan is a type of retirement plan where an employer contributes into a pool of funds set aside for a worker’s future benefit. The pool of funds is invested on the employee’s behalf, and the earnings on the investments generate an income to the worker upon retirement.
How does a Pension Plan work?
In a typical pension plan, the employer contributes money to the plan while the employee is working. The funds in the plan are then invested, and the employee receives the benefits of the plan when they retire. The amount of money the employee will receive often depends on several factors, such as their salary and how long they have worked for their employer.
What are the types of Pension Plans?
There are two main types of pension plans: defined benefit plans and defined contribution plans. In a defined benefit plan, the employer guarantees the employee a specific amount of benefit upon retirement, regardless of the performance of the underlying investment pool. In a defined contribution plan, the employer makes specific plan contributions for the worker, but the final amount of benefit received depends on the investment’s performance.
What is the difference between a Pension Plan and a 401(k)?
A pension plan is funded by the employer, while a 401(k) is funded by the employee. In a pension plan, the benefit amount is typically determined by a formula based on factors such as salary history and years of employment, while in a 401(k), the benefit amount depends on the individual’s investment returns.
Can a Pension Plan run out of money?
While it’s not common, it’s possible for a pension plan to run out of money. This generally happens if the company funding the plan goes bankrupt and has not invested the funds properly, or if the investments made with the pension plan funds perform poorly in the markets.
Related Entrepreneurship Terms
- Defined Benefit Plan
- Defined Contribution Plan
- Annuity
- Vesting Period
- Retirement Fund
Sources for More Information
- Internal Revenue Service (IRS) – The U.S. government agency that collects taxes and administers the Internal Revenue Code (the main body of federal statutory tax law).
- U.S. Department of Labor (DOL) – A department of the U.S. government that fosters, promotes, and develops the welfare of wage earners, job seekers, and retirees.
- Social Security Administration (SSA) – An independent agency of the U.S. federal government that administers social security, a social insurance program consisting of retirement, disability, and survivors’ benefits.
- Investopedia – A leading source of financial content on the web, with more than 30 million unique visitors and 90 million page views each month.
