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Submitted by: Frank Armstrong
Frank Armstrong, is President and founder of Investor Solutions, Inc. He is a pioneer in integrating academically driven portfolio management techniques with institutional best practices for individual investors around the world. Frank has over 30 years experience in the securities and financial services industry. He holds a B.A. in Economics from the University of Virginia and is a CERTIFIED FINANCIAL PLANNER® practitioner.
Introduction
Along with Social Security and personal savings, pension plans are a critical leg of the three corner stool that makes up our retirement security. Yet few plan participants actually understand how they work.
If you participate in a company pension plan, all or part of your retirement needs may be met by the plan. Or, maybe not! A number of interesting things could happen to your plan along the way, as we shall see. Beginning with the failure of Enron and the implosion of its retirement plans, Americans (and their legislators and regulators) began to focus on just how secure the system actually is. What they found wasn’t always pretty.
Since retirement plans are often the largest single asset a family has, it’s imperative that we all understand how they work, how to calculate present and future benefits, and what things to beware of. Knowing that, we can plan to maximize the all the possible benefits for ourselves and our families.
Before we delve into detail on the different types of plans, let’s give ourselves a tour of the landscape.
At first glance, there may appear to be so many different types of plans that you could never figure them out. To make matters worse, there may be several different names for the same type plans. But, it’s really quite simple.
Qualified and Non-Qualified Plans
“Non-qualified plans” can vary almost as widely as the imagination of the participants. They are simply private contracts between an employer and selected employees. They have no special tax status, enjoy no protection from the firm’s creditors, have no segregated assets to guarantee benefits, are not regulated by the terms of the Employee Retirement Security Act (ERISA), and may discriminate in any way the employer chooses. These arrangements can be quite informal, and some are not even reduced to writing. Or, they can be quite elaborate, including detailed formulas, vesting schedules, forfeiture provisions, stock options, phantom stock and golden handshake provisions. No two of them are alike, and we won’t be spending any more time on them in this series.
“Qualified plans” are given special tax treatment by the IRS in order to encourage systematic retirement savings. The alternative is to support a lot of their citizens on welfare later, so they offer up some pretty compelling advantages. In general terms, all contributions to qualified plans get a full tax deduction (within the limits of the code), and all earnings within the plan are deferred until distributed. Most employees will find that when the money is ultimately paid out to them, they are taxed at a lower rate than when the money was earned. The combined benefits of deductions, deferrals and lower brackets can be enormous. Additionally, the funds deposited for qualified plans go into separate trusts that are not subject to a company’s creditors, providing the employees a level of security not available to non-qualified plans.
But, along with the tax carrots, come some big sticks to ensure that the funds are actually used for the intended purpose. All qualified plans must be continuously approved by the IRS, and are monitored by both the IRS and Labor Department for compliance with applicable regulations. They must be operated in the sole interest of the participants, file tax returns, and may require annual testing for anti-discrimination, funding, and other administrative issues. So, even not so complex plans come complete with substantial administrative overhead and its associated costs.
Types of Qualified Plans
Qualified plans come in three flavors: defined benefit, defined contribution, and IRA’s. There are some hybrids, but chances are you have one or more of these three. If you understand how these work, you can quickly grasp the more exotic variations. The following sections oversimplify in order to make the distinctions clear:
Defined Benefit Plans (DB Plans) are exactly what the name implies. A formula defines exactly what benefit you should receive at some point in the future. This is the traditional plan your father or grandfather might have had. At your retirement age of 65 we will send you a check for some amount as long as you live.
The company works backwards from the future benefit (which the company sees as a liability) to determine if funding is adequate at each point along the way. On an annual basis they determine if fund’s current account balance along with future deposits – all earning a reasonable return – have them on track to pay out what each employee is due at retirement.
Defined Contribution Plans (DC Plans) are also exactly what the name implies. There is a formula that defines what the company and participant contributions will be, and the benefit is whatever the funds and their accumulated earnings are worth at the time of retirement. DC Plans include profit sharing, 401(k) and the so called Money Purchase Pension Plan. The later is a fixed commitment percentage of compensation funded entirely by company contributions and without regard to whether or not the company has made a profit.
DC Plans are becoming the norm, a situation not universally celebrated by potential retirees.
Individual Retirement Accounts (IRA’s) are special defined contribution plans funded for (and usually by) individuals and/or a means for individuals to rollover their benefits when they terminate from a qualified plan. As a substitute or supplement for a company pension plan, they are simpler to set up and maintain, but may not allow for as large an annual contribution as the company retirement plan might. When used as a rollover account, it allows the participant to continue to receive the benefits of tax deferral until after retirement. Rollover accounts make pension accounts portable when a participant changes employment.
The new Roth IRA provides an interesting alternative to traditional IRA’s because while they do not allow for a current tax deduction for contributions, the benefits can be completely tax free when paid out, and are not subject to any required minimum distribution rules.
From both the employer’s and employee’s perspective each of these types of plans has its own set of challenges and opportunities, risks and rewards. In some, the employee exercises a great deal of control, while in others he may just be along for the ride. Never-the-less, knowing the options and ground rules will pay big dividends, and allow you to maximize the benefits available from your plans.
Future articles will explore how these pension plans operate in greater detail.
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