The second type of employer-sponsored retirement plan, a defined-benefit retirement plan, pays lifetime monthly annuity payments to retirees based on a predetermined formula, usually in the form of annuity payments to retirees. It is commonly called a “pension” or a “final-average plan.” A pension is a sum of money paid regularly as a retirement benefit. Pensions are paid to retirees, and sometimes their survivors, by the Social Security Administration, various government agencies, and some employers. Benefits in defined-benefit plans are based on the years of service at the employer average pay in the last few working years, and a percentage. For example, an employee might have a defined annual retirement benefit of 2 percent multiplied by the number of years of service and multiplied by the average annual income during the last five years of employment. In this example, a worker with 20 years’ service and an average income of $48,000 over the last five years of work would have an annual benefit of $19,200 (20 x 0.02 x $48,000), or $1600 per month. In another example, an employee with 30 years of service might qualify for 60 percent of the average income over the last five years of work. With a $48,000 average salary over those five years, this worker might receive $28,800 annually, or $2400 per month.
Since the employer contributes all the money, it assumes all the investment risks associated with creating sufficient funds to pay future benefits. Defined-benefit plans were the “standard” a generation ago, but today they are offered by less than onefourth of employers, primarily because the other retirement plan alternatives are less costly. Some employers offer both defined-benefit and defined-contribution plans to their employees. Vesting requirements and participant rights are the same for all retirement plans.
Normal or Early Retirement? The earlier you retire, the smaller your monthly retirement pension from a defined-benefit plan will be because you will likely receive income for more years as a retired person. To illustrate, assume you are eligible for a full retirement pension of $24,000 per year at age 65. Your benefit may be reduced 5 percent per year if you retire at age 58 or reduced 3 percent per year if you retire at age 62. Smaller monthly pension payments are paid to the early retiree in a defined-benefit plan so that he or she will receive, in theory, the same present value amount of benefits as the person who retires later. The financial advantage of taking early retirement depends in part on the person’s life expectancy and the rate at which benefits are reduced. People who expect to live for a shorter period than the average expectancy may achieve a better financial position by retiring early. Most employees are allowed to work for as long as they choose, but companies generally do not increase benefits for employees who postpone retirement beyond age 65.
Disability and Survivors Benefits Survivors and disability benefits also represent concerns for workers who have spouses or children or are financially responsible for caring for others. A person’s full retirement pension forms the basis for any benefits paid to survivors and, when part of a retirement plan, for disability benefits as well. Disability benefits can be paid to employees whobecome disabled prior to retirement. People receiving either survivors or disability benefits are entitled to an amount that is substantially less than the full retirement amount. For example, if you were entitled to a retirement benefit of $2000 per month, your disability benefit might be only $1100 per month.
If a survivor is entitled to benefits, that pension amount must be paid over two people’s lives instead of a single person’s life; consequently, the monthly payment is different. Using the benefit described in the preceding example, if your surviving spouse is five years older than you, he or she might be entitled to $1300 per month. In contrast, if your spouse is five years younger, he or she might be entitled to only $900 per month.
A qualified joint and survivor benefit (or survivor’s benefit) is an annuity whose payments continue to the surviving spouse after the participant’s death, often equal to at least 50 percent of the participant’s benefit. This requirement can be waived if desired, but only after marriage not in a prenuptial agreement. Federal law dictates that a spouse or ex-spouse who qualifies for benefits under the plan of a spouse or former spouse must agree in writing to a waiver of the spousal benefit. This spousal consent requirement protects the interests of surviving spouses. If the spouse does waive his or her survivors benefits, the worker’s retirement benefit will increase. Upon the worker’s death, the spouse will not receive any survivors benefits when a waiver has been signed. Unless a spouse has his or her own retirement benefits, it is usually wise to keepthe spousal benefit.
Cash-Balance Plan The Newest Retirement Deal
A number of employers have established or amended their existing retirement plans to create a third type of employersponsored retirement plan, a hybrid of the defined-contribution and defined-benefit plans. A cash-balance plan is a definedbenefit plan that gives each participant an interest-earning account credited with a percentage of pay on a monthly basis. It is distinguished by the “balance of money” in an employee’s account at any point in time. The employer contributes 100 percent of the funds and the employees contribute nothing. The employer contributes a straight percentage of perhaps 5 percent of the employee’s salary every payday to his or her specific cashbalance account. Interest on cash-balance accounts is credited at a rate (perhaps 5 percent) guaranteed by the employer, and the employer assumes all the investment risk. As a result, the amount in the account grows at a regular rate. Employees can look ahead 5 or 25 years and calculate how much money will be in their account.
Vesting requirements for cash-balance plans are the same as those for other employer-sponsored retirement plans. At separation from employment or retirement, the vested employee has the right to all money in the account. Many large employers are shifting to cash-balance retirement plans in part because they are often much less costly to administer. Cash-balance plans are controversial because when substituted for a defined-benefit plan, they typically give older workers smaller benefits. Recognizing this concern, many cashbalance plans now provide a higher contribution, sometimes as large as 10 percent, for those employees age 55 and older. Younger workers who are more inclined to move from job to job may appreciate a benefit that can move with them, rather than one that offers a substantial payout only after decades of job loyalty.
Additional Employer-Sponsored Plans
Some employers offer supplemental savings plans to employees. ESOP An employee stock-ownership plan (ESOP) is a benefit plan through which the employer makes tax-deductible gifts of company stock into a trust, which are then allocated into accounts for individual employees. When employees leave the company, they get their shares of stock and can sell them. In effect, the retirement fund consists of stock in the company. If the company prospers over time, the employees will own some valuable stock; if the company does poorly or goes bankrupt, the stock may be worthless. To be properly diversified, experts recommend that employees have no more than 10 percent of their retirement assets invested in their employer’s company stock. The 2006 Pension Protection Act provides that companies cannot require that you buy company stock to qualify for a match. If your contributions continue to be matched with stock, you are able to trade out of those shares after three years. If you already own company shares, you can sell a third at a time, over three years.
Profit-Sharing Plan A profit-sharing plan is an employer-sponsored plan that shares some of the profits with employees in the form of end-of-year cash or common stock contributions to employees’ 401(k) accounts. The level of contributions made to the plan may reflect each person’s performance as well as the level of profits achieved by the employer. Contributions might be fixed (perhaps at 10 percent of profits) or be discretionary. They can vary from year to year. Some companies offer a voluntary profit-sharing plan through which employees can regularly purchase shares of stock in the company at discounted prices.
Disability and Survivors Benefits Survivors and disability benefits also represent concerns for workers who have spouses or children or are financially responsible for caring for others. A person’s full retirement pension forms the basis for any benefits paid to survivors and, when part of a retirement plan, for disability benefits as well. Disability benefits can be paid to employees whobecome disabled prior to retirement. People receiving either survivors or disability benefits are entitled to an amount that is substantially less than the full retirement amount. For example, if you were entitled to a retirement benefit of $2000 per month, your disability benefit might be only $1100 per month.
If a survivor is entitled to benefits, that pension amount must be paid over two people’s lives instead of a single person’s life; consequently, the monthly payment is different. Using the benefit described in the preceding example, if your surviving spouse is five years older than you, he or she might be entitled to $1300 per month. In contrast, if your spouse is five years younger, he or she might be entitled to only $900 per month.
A qualified joint and survivor benefit (or survivor’s benefit) is an annuity whose payments continue to the surviving spouse after the participant’s death, often equal to at least 50 percent of the participant’s benefit. This requirement can be waived if desired, but only after marriage not in a prenuptial agreement. Federal law dictates that a spouse or ex-spouse who qualifies for benefits under the plan of a spouse or former spouse must agree in writing to a waiver of the spousal benefit. This spousal consent requirement protects the interests of surviving spouses. If the spouse does waive his or her survivors benefits, the worker’s retirement benefit will increase. Upon the worker’s death, the spouse will not receive any survivors benefits when a waiver has been signed. Unless a spouse has his or her own retirement benefits, it is usually wise to keepthe spousal benefit.
Cash-Balance Plan The Newest Retirement Deal
A number of employers have established or amended their existing retirement plans to create a third type of employersponsored retirement plan, a hybrid of the defined-contribution and defined-benefit plans. A cash-balance plan is a definedbenefit plan that gives each participant an interest-earning account credited with a percentage of pay on a monthly basis. It is distinguished by the “balance of money” in an employee’s account at any point in time. The employer contributes 100 percent of the funds and the employees contribute nothing. The employer contributes a straight percentage of perhaps 5 percent of the employee’s salary every payday to his or her specific cashbalance account. Interest on cash-balance accounts is credited at a rate (perhaps 5 percent) guaranteed by the employer, and the employer assumes all the investment risk. As a result, the amount in the account grows at a regular rate. Employees can look ahead 5 or 25 years and calculate how much money will be in their account.
Vesting requirements for cash-balance plans are the same as those for other employer-sponsored retirement plans. At separation from employment or retirement, the vested employee has the right to all money in the account. Many large employers are shifting to cash-balance retirement plans in part because they are often much less costly to administer. Cash-balance plans are controversial because when substituted for a defined-benefit plan, they typically give older workers smaller benefits. Recognizing this concern, many cashbalance plans now provide a higher contribution, sometimes as large as 10 percent, for those employees age 55 and older. Younger workers who are more inclined to move from job to job may appreciate a benefit that can move with them, rather than one that offers a substantial payout only after decades of job loyalty.
Additional Employer-Sponsored Plans
Some employers offer supplemental savings plans to employees. ESOP An employee stock-ownership plan (ESOP) is a benefit plan through which the employer makes tax-deductible gifts of company stock into a trust, which are then allocated into accounts for individual employees. When employees leave the company, they get their shares of stock and can sell them. In effect, the retirement fund consists of stock in the company. If the company prospers over time, the employees will own some valuable stock; if the company does poorly or goes bankrupt, the stock may be worthless. To be properly diversified, experts recommend that employees have no more than 10 percent of their retirement assets invested in their employer’s company stock. The 2006 Pension Protection Act provides that companies cannot require that you buy company stock to qualify for a match. If your contributions continue to be matched with stock, you are able to trade out of those shares after three years. If you already own company shares, you can sell a third at a time, over three years.
Profit-Sharing Plan A profit-sharing plan is an employer-sponsored plan that shares some of the profits with employees in the form of end-of-year cash or common stock contributions to employees’ 401(k) accounts. The level of contributions made to the plan may reflect each person’s performance as well as the level of profits achieved by the employer. Contributions might be fixed (perhaps at 10 percent of profits) or be discretionary. They can vary from year to year. Some companies offer a voluntary profit-sharing plan through which employees can regularly purchase shares of stock in the company at discounted prices.
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