Pension

A pension is a steady income paid to a person (usually after retirement). Retirement plans (also known as superannuation) are a product or a method of investing which invests money now to provide for a retirement pension later.

Pension

A pension is a steady income paid to a person (usually after retirement). Retirement plans (also known as superannuation) are a product or a method of investing which invests money now to provide for a retirement pension later.

Although a lottery may provide a pension, most lotteries today give an annuity for a fixed number of years, like 25 years. Only some lotteries give an annuity for life, like the failed New York State's "Win for Life" lottery, which paid the winner $2000 per week for life. The common use of the term is to describe the payments a person receives upon retirement, usually under pre-determined legal and/or contractual terms.

Pensions have traditionally been payments made in the form of a guaranteed annuity to a retired or disabled employee, or to a deceased employee's spouse, children, or other beneficiaries. A pension created by an employer for the benefit of an employee is commonly referred to as an occupational or employer pension. Labor unions, the government, or other organizations may also sponsor pension provision.

Contents:
1 Types of pensions
1.1 Pension plan or retirement plan
1.2 Requirement of Permanence
1.3 Defined Benefit Plans
1.4 Defined Contribution Plans
1.5 Hybrid and Cash Balance Plans
2 Financing
3 Current Challenges
4 Pension systems in various countries
5 Political pensions

Types of pensions

Pension plan or retirement plan

By such an arrangement an employer (for example, a corporation, labor union, government agency) provides income to its employees after retirement. Pension plans are a form of "deferred compensation" and became popular in the United States during World War II, when wage freezes prohibited outright increases in workers' pay.

Pension plans can be divided into two broad types: Defined Benefit and Defined Contribution plans. The defined benefit plan had been the most popular and common type of pension plan in the United States through the 1980s; since that time, defined contribution plans have become the more common type of retirement plan in the United States and many other western countries.

Some plan designs combine characteristics of defined benefit and defined contribution types, and are often known as "hybrid" plans. Such plan designs have become increasingly popular in the US since the 1990s. Examples include Cash Balance and Pension Equity plans.

Requirement of Permanence

To guard against tax abuse in the United States, the Internal Revenue Service (IRS) has promulgated rules that require that pension plans be permanent as opposed to a temporary arrangement used to capture tax benefits. Regulation 1.401-1(b)(2) states that "[t]hus, although the employer may reserve the right to change or terminate the plan, and to discontinue contributions thereunder, the abandonment of the plan for any reason other than business necessity within a few years after it has taken effect will be evidence that the plan from its inception was not a bona fide program for the exclusive benefit of employees in general. Especially will this be true if, for example, a pension plan is abandoned soon after pensions have been fully funded for persons in favor of whom discrimination is prohibited..." So no games with quickie plan set up followed up quickie terminations. The IRS would have grounds to disqualify the plan retroactively even if the plan sponsor initially got a favorable determination letter. Determination letters like "'no-action letters'" from the Securities and Exchange Commission (SEC) are advisory and to the extent the tax-payer's actions have strayed the taxpayer is on the hook.

Defined Benefit Plans

In the United States, by statute all pension plans that are not defined contribution plans (see 26 U.S.C. § 414(j) " For purposes of this part, the term “defined benefit plan” means any plan which is not a defined contribution plan. ") are defined benefit plans. This quirk in the Internal Revenue Code places hybrid plans within the defined benefit ambit.

The typical defined benefit plan (as its name implies) defines a benefit for an employee upon that employee's retirement. The benefit in a defined benefit pension plan is determined by a formula, which can incorporate the employee's pay, years of employment, age at retirement, and other factors. A simple example is a flat dollar plan design that provides $100 per month for every year an employee works for a company; with 30 years of employment, that participant would receive $3,000 per month payable for their lifetime. Typical plans in the United States are final average plans where the average salary over the last three or five years of an employees' career determines the pension; in the United Kingdom, benefits are often indexed for inflation. Formulas can also integrate with public Social security plan provisions and provide incentives for early retirement (or continued work).

Traditional defined benefit plan designs (because of their typically flat accrual rate and the decreasing time for interest discounting as people get closer to retirement age) tend to exhibit an S-shaped accrual pattern of benefits, where the present value of benefits grows quite slowly early in an employees' career and accelerates significantly in mid-career. Defined benefit pensions are usually not portable - accrued benefits in defined benefit plans are typically payable only at retirement - even when the employee has a vested interest in the benefit. However, if he employer amends the plan document to allow a lump sum cash benefit at termination, it would be just as portable as defined contribution plans, but this has not been industry practice for all but the cash balance plan version of defined benefit plans. On the other hand, defined benefit plans typically pay their benefits as an annuity, so retirees do not bear the risk of outliving their retirement income.

The United States Social Security system is similar to a defined benefit pension arrangement, albeit one that is constructed differently than a pension offered by a private employer.

The "cost" of a defined benefit plan is not easily calculated, and requires an actuary or actuarial software. However, even with the best of tools, the cost of a defined benefit plan will always be a estimate based on economic and financial assumptions. These assumptions include the average retirement age and life span of the employees, the returns earned by the pension plan's investments and the cost of insurance from the Pension Benefit Guaranty Corporation which is predicted to increase in the near future. So, for this arrangement, the benefit is known but the contribution is unknown even when calculated by a professional.

Defined Contribution Plans

In the United States, a defined contribution plan is generally defined as a plan providing for an individual account for each participant, and for benefits based solely on the amount contributed to the account, plus or minus income, gains, expenses and losses allocated to the account (see 26 U.S.C. § 414(i)). Plan contributions are paid into an individual account for each member. The contributions are invested, for example in the stock market, and the returns on the investment (which may be positive or negative) are credited to the individual's account. On retirement, the member's account is used to provide retirement benefits, often through the purchase of an annuity which provides a regular income. Defined contribution plans have become more widespread all over the world in recent years, and are now the dominant form of plan in the private sector in many countries. For example, the number of defined benefit plans in the US has been steadily declining, as more and more employers see the large pension contributions as a large expense that they can avoid by disbanding the plan and instead offering a defined contribution plan.

Examples of defined contribution plans in the United States include Individual Retirement Accounts (IRAs) and 401(k) plans. In such plans, the employee is responsible, to one degree or another, for selecting the types of investments toward which the funds in the retirement plan are allocated. This may range from choosing one of a small number of pre-determined mutual funds to selecting individual stocks or other securities. Most self-directed retirement plans are characterized by certain tax advantages, and some provide for a portion of the employee's contributions to be matched by the employer. In exchange, the funds in such plans may not be withdrawn by the investor prior to reaching a certain age--typically the year the employee reaches 59.5 years old--(with a small number of exceptions) without incurring a substantial penalty.

Money contributed can either be from employee salary deferral or from employer contributions or matching. Defined contribution plans are subject to IRS limits on how much can be contributed, known as the section 415 limit. The total deferral amount including the employee and employer contribution is the lesser of $40,000 or 100% of compensation. The employee only amount is $13,000 for 2004 with a $3,000 catch up. These amounts increase in 2005 (to $14,000 and $4,000) and 2006 (to $15,000 and $5,000).

The portability of defined contribution pensions is legally no different from the portability of defined benefit plans. However, because of the cost of administration and ease of determining the plan sponsor's liability for defined contribution plans (you don't need to pay a actuary to calculate the lump sum equivalent under Section 417(e) that you do for defined benefit plans) in practice, defined contribution plans have become generally portable.

In a defined contribution plan, investment risk and investment rewards are assumed by each individual/employee/retiree and not by the sponsor/employer. In addition, participants do not typically purchase annuities with their savings upon retirement, and bear the risk of outliving their assets.

The "cost" of a defined contribution plan is readily calculated, but the benefit from a defined contribution plan depends upon the account balance at the time an employee is looking to use the assets. So, for this arrangement, the contribution is known but the benefit is unknown (until calculated).

Despite the fact that the participant in a defined contribution plan typically has control over investment decisions, the plan sponsor retains a significant degree of fiduciary responsibility over investment of plan assets, including the selection of investment options and administrative providers.

Hybrid and Cash Balance Plans

Hybrid plan designs combine the features of defined benefit and defined contribution plan designs. In general, they are usually treated as defined benefit plans for tax, accounting and regulatory purposes. As with defined benefit plans, investment risk in hybrid designs is largely borne by the plan sponsor. As with defined contribution designs, plan benefits are expressed in the terms of a notional account balance, and are usually paid as cash balances upon termination of employment. These features make them more portable than traditional defined benefit plans and perhaps more attractive to a more highly mobile workforce. A typical hybrid design is the Cash Balance Plan, where the employee's notional account balance grows by some defined rate of interest and annual employer contribution.

In the US, plan conversions from traditional to hybrid plan designs have been controversial, notably at IBM in the late 1990s. Upon conversion, some plan sponsors retrospectively calculated employee account balances -- if the employee's actual vested benefit under the old design was more than the account balance, the employee entered a period of wear away where he or she accrued no new benefits. Hybrid designs also typically eliminated the generous early retirement provisions in traditional pensions.

As a result, critics of cash balance plans have seen the new designs as discriminatory against older workers. On the other hand, the new designs may better meet the needs of a modern workforce and actually encourage older workers to remain at work, since benefit accruals continue at a constant pace as long as an employee remains on the job. Court cases have split on this issue and therefore not resolved these problems. Currently both the Senate and House have legislation to clarify the legal status of future cash balance plans. In the interim, Treasury has placed a moratorium on future determination letters on cash balance plans. The proposed legislation on cash balance age discrimination (much like the principle in criminal appeal that convicts convicted under the old procedure cannot win on appeal by applying the new rule retroactively US v. Teague, 489 US 288 (1989)) does not cover the legal status of current plans in existence.

While the Cash Balance Plan mentioned above is hybrid which is a defined benefit plan designed enable workers to evaluate the economic worth their pension benefit in the manner of a defined contribution plan (the Defined Benefit design of Cash Balance plans provides the advantage of PBGC insurance but the risk of insolvency), the Target Benefit plan is a defined contribution plan designed to express its projected impact in terms of lifetime income as a percent of final salary at retirement and targeted to match a defined benefit plan. In a Target Benefit plan, a typical Defined Benefit design, say 1.5% of salary per year of service times the final 3-year average salary, is used to provide the target. Actuarial assumptions like 5% interest, 3% salary increases and the UP84 Life Table for mortality are used to calculate a level flat contribution rate that would create the needed lump sum at retirement age 65 for each entering employee.

The problem with such Target Benefit DC plans is that the flat rate could be low for young entrants, like 8% for a 21 year old, and high for old entrants. This may appear unfair. But the skewing of benefits to the old worker is a feature of most traditional defined benefit plans; and any attempt to match it would reveal this backloading feature.

This points out the key difference among DC and DB plans for ordinary workers -- awareness. The DC plan like the 401k is easy for workers to understand the value of, while the DB plan is typically undervalued by workers until they get really close to retirement age.

Financing a Pension

There are various ways in which a pension may be financed.

In a funded defined contribution pension, contributions are paid into a fund during an individual's working life. The fund will be invested in assets, such as stocks, bonds and property, and grow in line with the return on these assets. (An unfunded defined contribution pension is an oxymoron.)

In an unfunded defined benefit pension, no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid. Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly from current workers' contributions and taxes. This method of financing is known as Pay-as-you-go. It has been suggested that this model bears a disturbing resemblance to a Ponzi scheme.

In a funded defined benefit arrangement, an actuary calculates the contributions that the plan sponsor must make to ensure that the pension fund will meet future payment obligations. This means that in a defined benefit pension, investment risk and investment rewards are typically assumed by the sponsor/employer and not by the individual. If a plan is not well-funded, the plan sponsor may not have the financial resources to continue funding the plan. In the United States, private employers must pay an insurance-type premium to the Pension Benefit Guaranty Corporation, a government agency whose role is to encourage the continuation and maintenance of voluntary private pension plans, provide timely and uninterrupted payment of pension benefits.

Current Pension Challenges

A growing challenge for many nations is population ageing. As birth rates drop and life expectancy increases an ever-larger portion of the population is elderly. This leaves fewer workers for each retired person. In almost all developed countries this means that the pension system will eventually go broke unless reformed. The two exceptions are Australia and Canada, where the pension system will be solvent for the foreseeable future. In Canada, for instance, the annual payments were increased by some 70% in 1998 to achieve this. These two nations also have an advantage from their relative openness to immigration. However, their populations are not growing as fast as the U.S., which supplements a high immigration rate with one of the highest birthrates among Western countries. Thus, the population in the U.S. is not aging to the extent as those in Europe, Australia, or Canada.

Another growing challenge is the recent trend of businesses, like an airline company or computer firm, purposely underfunding one their pension funds in order to push the costs onto the federal government. Bradley Belt, executive director of the PBGC (the Pension Benefit Guaranty Corporation, the federal agency that insures private-sector defined-benefit pension plans in the event of bankruptcy), testified before a congressional hearing in October 2004, “I am particularly concerned with the temptation, and indeed, growing tendency, to use the pension insurance fund as a means to obtain an interest-free and risk-free loan to enable companies to restructure. Unfortunately, the current calculation appears to be that shifting pension liabilities onto other premium payers or potentially taxpayers is the path of least resistance rather than a last resort.”

Pension systems in various countries
Canada Pension Plan
Compulsory Superannuation in Australia
Indian pension system
Social security (Sweden)
Retirement plans in the United States
Social security (United States)
UK Pension Provision
Self-invested personal pensions (UK)

Political pensions

This is a type sui generis as it is not awarded on grounds of justice, contract or socio-economic merits, but as a political decision, in order to take a politically significant person (often deemed a potential political danger) out of the picture by paying him or her off, regardless of seniority.

In British colonial history, the term political pensioner applies thus to the following former ruling houses of princely states who saw their feudal territories annexed by the HEIC before it transferred power in British India to the Crown in 1858. Although politically important members could be relocated or exiled, they retained throughout the Raj a hereditary right to their former princely rank and titles (in several cases including a gun salute) as well as a monetary "political pension" as a private purse. Only a few years after India's 1947 independence, the nationalist government 'persuaded' most of them to reliquish the annual pension sum on so-called patriotic grounds. For those who continued to receive their payments, the sums were allowed to become a pittance through uncompensated inflation.
The imperial Mughal Family of Padishahs of Delhi
its failed Muslim fundamentalist challenger, Tippu Sultan's Mysore-based Khudadad empire
Angre
Arcot (the Carnatic)
Assam (not the whole present state)
Awadh (Oudh)
Bengal
Coorg
Kolaba
Kurnool
Masulipatam
Murshidabad
Nagpur
Punjab's last ruling sikh maharajah Duleep Singh
Satara
Surat
Tanjore

Similar arrangements were often made later by other governments.

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