Private pensions, Social Security, and personal savings are the main sources of retirement income.

Private pension plans are covered by the Employee Retirement Income Security Act (ERISA), which sets guidelines and minimum standards for them. ERISA also provides insurance for pension funds through the Pension Benefit Guaranty Corporation (PBGC). PBGC acts the same way as deposit insurance at savings institutions. If a pension fund should fail, the insurance covers retirees and future retirees who were vested in the fund. However, they may not be fully covered.

Being vested in a pension fund means you have earned the right to payments from the fund, even though your employment with an organization may have ended before you reached retirement age. ERISA provides, under most pension plans, that employees must be vested according to one of the following schedules: full (100 percent) vesting upon completion of five years of service; or 20 percent vesting after three years of service, and then 20 percent vesting per year thereafter until the participant is 100 percent vested after seven years of service.

Pension plans also credit years of service differently. Some only start the clock at age 21; therefore, if you started work at 18, you would have 3 years of service before you started earning service credit in the pension system. Breaks in service are also handled differently by different plans. Breaks in service for up to 5 years do not result in any loss of credit; some pensions may allow longer breaks. Also, many plans stop the clock at age 65 if you work beyond that age, added years are not credited to your record.

Under the Retirement Equity Act (REA) of 1984, all married pension participants with vested benefits must automatically be provided upon their retirement with (1) a qualified preretirement survivor annuity and (2) a qualified joint and survivor annuity. These annuities must be provided, regardless of the age of the participant, and can be waived only with the consent of the spouse.

Generally speaking, there are two types of pension plans: defined benefit plans and defined contribution plans.  

Defined Benefit Plan

For a defined benefit plan, the benefit formula is set out and contributions are made to the fund so the necessary amount of money will be there when needed. The amount of the contribution depends on the interest rate the fund managers think it will earn. During periods of high interest, contributions can be smaller, since interest will make up a larger share of money.  

Defined Contribution Plan

A defined contribution plan, on the other hand, does not promise you a specific amount of benefits at retirement. In these plans, you or your employer (or both) contribute to your individual account under the plan, sometimes at a set rate, such as 5 percent of your earnings annually. These contributions generally are invested on your behalf. You will ultimately receive the balance in your account, which is based on contributions plus or minus investment gains or losses. The value of your account will fluctuate due to the changes in the value of your investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.  

Examples of Defined Benefit Plans and Defined Contribution Plans

Listed below are specific examples of defined benefit plans and defined contribution plans.    

401(k) Plans 

Your employer may establish a defined contribution plan that is a cash or deferred arrangement, usually called a 401(k) plan. You can elect to defer receiving a portion of your salary which is instead contributed on your behalf, before taxes, to the 401(k) plan. Sometimes the employer may match your contributions. There are special rules governing the operation of a 401(k) plan.

 

 

Cash Balance Plan

A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.  The U.S. Department of Labor, Pension and Welfare Benefits Administration provides additional information about cash benefit plans.

 

Employee Stock Ownership (ESOPs)

Employee stock ownership plans (ESOPs) are a form of defined contribution plan in which the investments are primarily in employer stock. Congress authorized the creation of ESOPs as one method of encouraging employee participation in corporate ownership.

 

Money Purchase Pension

A money purchase pension plan is a plan that requires fixed annual contributions from your employer to your individual account. Because a money purchase pension plan requires these regular contributions, the plan is subject to certain funding and other rules.

 

Profit Sharing Plans/Stock Bonus Plans

A profit sharing or stock bonus plan is a defined contribution under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution. A profit sharing plan or stock bonus plan include a 401(k) plan.