When you’re on the lookout for a new job, you will most likely focus on the salary above everything else. Clearly, the amount of money you’ll be taking home every month is important, but don’t let this number blind you to the rest of the package. Smart companies will be thinking in terms of a TCE (Total Cost of Employment) figure; so should you.
From their perspective, this includes expenses like payroll taxes from which you’ll get no direct benefit. Other components, however, like employer contributions to your medical insurance and retirement fund, are no less meaningful than your hourly wage. They’re a little less straightforward, though, so it’s crucial to understand your company pension plan and discover how you can maximize the benefits to yourself.
Table of Contents
- 1 How Does a Company Pension Work?
- 2 What Are the Best Company Pensions for Older/Younger Employees?
- 3 Your Company Pension Plan: Defined Benefit or Defined Contribution?
- 4 Pensions and Tax
- 5 What’s the Difference Between a Company Pension Plan, an IRA, and a 401(k)?
- 6 What Happens to Pensions when a Company Closes Down?
- 7 What Is My Pension Worth at the End of the Day?
- 8 How Does a Company Pension Plan Work? Who to Ask for More Information
- 9 Pension Vesting
How Does a Company Pension Work?
Death and taxes, we’re told, are the only two certainties in life. If you’re lucky and plan ahead, retirement happens somewhere between the two.
Bridging the gap between the time you stop working and the inevitable end requires two things: saving diligently and preventing the IRS from taking more than its fair share in tax. A pension plan is simply a financial vehicle that combines these two functions, with the added benefit that your nest egg is invested. Money in a pension generates interest and grows in between being deposited and taken out several years later.
When talking about a company pension plan, there is another very important factor to be aware of: though they’re a part of your total remuneration package, the contributions essentially come out of your employer’s pocket every month (don’t worry, they get some of it back in the form of tax breaks). This implies that you won’t have easy access to the money at any time, nor will you be always able to control how it’s invested. This happens to be true even if you choose to send part of your salary the way of the company pension plan, which is usually allowed – these voluntary contributions may or may not be matched by the company you work for.
Few people, on the other hand, have the time to learn how to be competent investors in their own right, so placing your retirement fund in the hands of professional managers is a good idea. Being forced to save consistently isn’t actually a bad thing either. Americans (and in fact people in general) are notoriously bad at planning for retirement, which is partly why so many people have no choice but to keep working when they should be enjoying a well-earned rest. The Bureau of Labor Statistics has estimated that over 40% of the U.S. workforce will be 65 or older by 2026 – wouldn’t you rather spend that time birdwatching, spending time with your grandchildren, or traveling the world?
- A company pension plan makes it easy to save for your retirement. Contributions to your nest egg can be made by you, your employer, or both.
What Are the Best Company Pensions for Older/Younger Employees?
We’ve mentioned in passing that some pension plans mandate the employer to set aside a certain amount for their employees’ retirement every month, most of them allow the employee to divert a portion of their paycheck to beef up their savings, and a number are organized in such a way that the company you work for “matches” your voluntary additions – i.e. contributes an amount linked to what you save, up to some limit. There’s another, more significant difference between various types of company pension plans, though:
Your Company Pension Plan: Defined Benefit or Defined Contribution?
As you would expect from the term used to describe it, a defined benefit company pension plan pays out a guaranteed dollar amount when you retire, specified either as a per-month annuity for as long as you live or a lump sum you can do with what you like. The specific amount is usually calculated based on the number of years you’ve been with the company and how much you earned while working there. A typical arrangement may look like this:
Defined Benefit = 1% x (no. of years worked) x (average salary)
If the underlying investments in the fund don’t perform as expected, the company is on the hook for the difference. Contrariwise, if the financial markets do better than expected, you don’t share in the additional gains.
When a company pension plan has a defined contribution, by contrast, you’re more exposed to the whims of the bond and stock markets. The amount you and/or your employer invests each month is fixed, and you may get out either more or less than you hoped for depending on how well your investments perform.
Defined-benefit plans are therefore safer in the sense that you know what you’re getting. As you get older, your ability to weather financial risks decreases simply because you don’t have the time to wait out market volatility – if you need cash, you have to liquidate some investments even if they’re currently worth less than their inherent value.
If you’re able to choose between these two types (which isn’t all that common, most workplaces offer one or the other but not both), you should ask yourself: “what is my pension worth, at the moment I retire, in the best and worst-case scenarios?”. For a defined-benefit plan, the answer is the same in both cases. If yours operates on the defined-contribution system, however, there may be a major discrepancy. It’s worth keeping in mind that U.S. debt levels – personal, corporate as well as public – are incredibly high these days. This, by itself, doesn’t make another financial crisis more likely, but it does have the potential to aggravate any shock and send asset prices tumbling.
If you’re locked into a defined-contribution company pension plan and you’re in your late fifties or older, in other words, you should tread carefully and perhaps place some of your savings into “recession-proof” investments. If you’re young and still have decades of earnings to look forward to, you have much more leeway and may well prefer a fixed-contribution plan.
- Defined benefit plans guarantee you a certain amount on retirement; defined contribution plans involve more risk.
Pensions and Tax
Is my pension taxable? The answer, unfortunately, is usually “yes”. On the bright side, the government does want people to save more for retirement, so there are some tax advantages to using a company pension fund. At the very least, whichever kind of retirement plan you have, your income will only be taxed once – they won’t get you coming as well as going.
The first important benefit to saving some of your paycheck in a formal pension scheme (assuming that it qualifies under Internal Revenue Code 401(a)) is that these are seen as “deferred” earnings. Since you postpone enjoying that money, it’s taken off your taxable income while you’re working and lowers your tax obligation.
While investments are growing your nest egg, you also needn’t pay tax on the increase, including capital gains, interest, and dividend income. This applies until you start withdrawing money from your pension fund. At this point, the IRS sees your withdrawals as normal income and you will have to pay federal and/or state taxes on it. Most people’s income and expenses are much lower once they don’t have to work, though, meaning that you pay a smaller portion overall.
What’s the Difference Between a Company Pension Plan, an IRA, and a 401(k)?
In one sense, all of these are pension plans: structured investment packages optimized for retirement savings. In everyday speech, though, many people take “company pension plan” to mean a fund bankrolled partly or wholly by the employer and managed by them or an investment company acting on their behalf. For the most part, these are defined benefit plans, but two other popular options are IRAs and 401(k)s.
The most noteworthy feature of a 401(k) plan is that it is of the defined contribution variety. There is no guaranteed amount to be paid out once you retire, but you may also do better than expected if the economy does. As this reduces the company’s risk of financial losses, 401(k)s have become much more common than traditional pensions in recent years, except for government workers.
Owners of a 401(k) have a fairly large amount of control over how their money is invested – this is not necessarily an advantage if they don’t understand the finer points of investing. On a more positive note, many employers make additional contributions matching those coming out of the employee’s paycheck. (If they offer a 50% match, they will deposit $500 into your pension plan for every $1,000 you do). These savings are pre-tax, meaning that you don’t pay income tax on this portion of your earnings until you start drawing on your 401(k).
An IRA works in much the same way but with one key difference: your employer will do all the administration involved in opening and managing a 401(k); for an IRA, you’ll have to visit a broker or bank. Prudent savers and investors may well take out an IRA of their own in addition to any company pension plan. There is also a special kind of IRA called a Roth: instead of putting off paying taxes on what you put in it, you do so immediately but don’t have to give a slice to the IRS when you withdraw money from it.
- In the vast majority of cases, the money you save towards retirement is deducted from your taxable income now (i.e. tax-free), but taxed normally when you withdraw it.
What Happens to Pensions when a Company Closes Down?
Very large employers, like the government, often manage their own pension funds. Smaller companies that offer defined benefit schemes will generally turn to financial institutions that do this on their behalf. Either the employer or the pension fund they subscribe to can theoretically go bankrupt, though, so where does this leave people relying on their pensions to survive?
Clearly, simply telling them “tough luck” would be far from ideal. The solution, which almost all private pension funds use, is the Pension Benefit Guaranty Corporation. Just like the Federal Deposit Insurance Corporation insures the contents of your bank accounts no matter what happens to the bank, the PBGC protects your benefits from disappearing altogether, though they may be reduced. You may want to double-check whether your company pension plan is indeed insured with the PBGC.
Most defined contribution pension plans, including 401(k)s and IRAs, don’t come with the same safety net. Many would argue that this would be both unnecessary and unethical: since these are investments, they belong to you rather than amounting to a legal obligation on your former employer. All investments can lose as well as gain value, too: if you can benefit from the upside, you have to accept the potential downside as part of the deal.
- Most defined benefit pension plans are federally guaranteed and will keep paying out even if a company goes under. Most defined contribution funds are not.
What Is My Pension Worth at the End of the Day?
Having something saved up for your retirement is infinitely better than relying only on Social Security payments or the kindness of family. It’s not enough by itself, though: you need to have a plan for life after work. This means being realistic about what kind of lifestyle you’re willing to accept, figuring out what it will cost, and knowing in advance how you will use your pension. This kind of planning isn’t always simple, but it will help you make much better decisions when the time comes around.
A privately managed company pension plan is sometimes used as a corporate strategy tool. Instead of declaring some employees redundant, for instance, management may decide to reduce costs by suggesting early retirement to their older workers. In this case, you may be offered a choice: start taking things easy a few years early but at the cost of a reduced payout. If you, on the other hand, want to retire early, you may be able to cash out a defined contribution plan if you’re willing to accept (or able to avoid) the early withdrawal penalties.
Inflation, too, takes a bite out of what you were expecting to receive at the end of your working days. With a defined contribution plan such as a 401(k), the increase in the value of the underlying assets should keep up or exceed the higher cost of living in future years. Defined benefit plans require you to be a little more careful: while some of them do adjust the amounts they pay out according to inflation, some only guarantee you a dollar amount, no matter how much or little those dollars can buy in the future.
There’s also the issue of whether to cash in your pension plan as a lump sum or opt for regular monthly payments. Choosing the former will usually mean accepting a slightly lower amount than what your contributions would have been worth if you’d invested them yourself. On the other hand, getting everything due to you in cash may work out in your favor, perhaps due to you using that money to pay off all your outstanding debts or starting a new life abroad. Most likely, the tax implications are what will make this decision for you: unless you roll over your payout into an IRA, you’ll probably be pushed into a higher income bracket and end up paying more than you’d otherwise have to.
Finally, with defined benefit plans paying a monthly amount, it’s important to know whether this is a single-life annuity or a “joint and survivor” payment. In the latter case, the checks will keep coming after your death for as long as your spouse lives. The payouts are typically lower if you select this option, though – you may be better off taking out a comprehensive life insurance policy instead. The only way to figure out which arrangement offers you the most advantages is to do the math, perhaps with the help of a financial advisor specializing in retirement planning.
- You have to be smart both when deciding on a company pension plan and at the time it comes due. There are some contingencies to keep in mind, so draw up a clear roadmap for your retirement.
How Does a Company Pension Plan Work? Who to Ask for More Information
Particularly when it comes to specific tax rules and investment options, you may find that the above information just doesn’t cover all the bases. To give one example, there are actually four different types of 401(k) plan, and that’s in addition to the very similar 403(b). There are simply too many special cases for one article to answer every question you may have; that’s what financial advisors are for.
If you’re in doubt as to what any particular wrinkle in your company pension plan means for you, your first port of call should be the human resources department. Almost all types of pension plans are governed by the 1974 Employee Retirement Income Security Act (ERISA), which among other things defines the plan’s sponsor – i.e. the employer – as a fiduciary with similar obligations to those of an accountant or broker. In addition, this law requires them to supply plan members with information on the plan’s funding and features.
However, as the saying goes, they can explain something to you, but they can’t necessarily understand it for you. It may be a good idea to consult a third party if anything seems unclear. While they presumably do their best, there’s also no guarantee that your company knows all about the best company pensions available. Being proactive and making suggestions may benefit everyone. You can, for instance, ask to invest in funds that charge lower fees, which is certainly a good idea if those that currently handle your money are taking more than one percent.
In particular, you may want to ask HR about your employer’s pension vesting policy. Companies use pensions and other perks to attract and retain the best employees. Having a company pension plan in place is therefore indirectly to their benefit…but only if it stops talented people from leaving.
For this reason, many pension plans include a provision barring employees from fully participating in the company pension scheme until they’ve worked there for a few years. The company will continue to make contributions on their behalf, but they don’t have any rights to the money until it “vests”. This often happens gradually over a period of up to seven years; if you leave the company before then, you may only be entitled to a fraction of the total sum stored in your pension.
Note that any pension payments out of your own pocket always remain yours: vesting applies only to money an employer pays into your pension fund. Just because you own it doesn’t mean that you can withdraw it in cash at any time, though, and it’s often financially worth it to tough out a job you don’t like just until, for example, your employer’s matching contributions to your 401(k) vest.
- Your employer is legally obligated to disclose all important information related to their company pension plan, but don’t expect them to play the role of your personal financial advisor.
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Understanding your company pension plan, and choosing between the best company pensions if you have that option, is something many people choose simply not to do. It’s certainly a lot of work if you don’t know much about finance, and it forces you to confront what may be uncomfortable questions about the future. What is my pension worth once taxes, inflation, and assorted fees have taken their pounds of flesh? How much do I need to be comfortable and free during my final years? What if I need expensive medical care?
The answers to these kinds of questions are going to be relevant sooner than you think. Careful planning will prevent a whole range of problems, and it starts with understanding your company pension plan.