Pension Systems

A pension is an income given to an individual after retirement. Different systems exist to provide and fund this pension, both private (generally employer-provided) and public (provided by the government). In the United States, Social Security is the closest analogue to a public pension system, though it is not traditionally referred to that way (notably, Social Security pays out at a given age instead of upon retirement, and as a social welfare program, it includes disability benefits). Pensions typically work like annuities, in that money is paid in during the deferral phase and paid out in periodic checks during the annuity phase. In the United States, employer-provided pension plans became more common during World War II, when scarcity of funds led to wage freezes and an increase in benefits such as pensions became the alternative to giving an employee a raise. Pension plans also encourage employee loyalty, since the eventual benefits increase the longer the employee works for the company, such that career moves that are lateral in salary and current benefits will generally be a step down in terms of overall benefits. The longer an employee has worked for a company, the more he or she has to lose by leaving for another position, which thus gives the greatest motivation to the most experienced workers.

Defined Benefit and Defined Contribution

In addition to the question of whether they are private or public, pension plans can be defined benefit or defined contribution, or a hybrid of the two. In the United States, it is typical to refer only to the defined benefit plan as a pension, but defined contribution plans have become the most common type of privately funded retirement plan in the country.

Defined contribution plans accrue from contributions paid into the plan over time, which are invested in stocks or mutual funds, with the returns of those investments affecting the individual's account balance. When the market as a whole takes a significant dip, part of the resulting panic is because of the number of people whose retirement plans are thus so influenced by market performance. Common defined contribution plans include the 401(k) and the Individual Retirement Account (IRA). The 401(k) is an employer-sponsored salary reduction plan: employees define a percentage of their paycheck to be diverted into the 401(k) account instead of disbursed to them, and any such earnings are tax deferred (taxed not in the year they were earned, but in the year they are disbursed [Page 1275]as benefits, further down the line). Some employers will match the employees contribution, in whole or in part, the specifics of which are agreed-upon when the plan is set up and signed. Defined contribution plans have the benefit of protecting employees from employer bankruptcy, a protection not offered by employer-sponsored defined benefit plans, which may be used to pay off an employer's debts in case of bankruptcy; while the Pension Benefit Guaranty Corporation, a federal agency created by the 1974 Employee Retirement Income Security Act (ERISA), ensures defined benefit pension plans, it does so with a cap on the maximum benefits, especially for benefits paid to early retirees (a great number of which can be expected when an employer goes bankrupt) and benefits paid to survivors of deceased employees.

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