How Pension Plans Work

Pension plans are just about extinct in the Fortune 500 world, but according to a recent Research Report, pension plans such as cash balance plans are seeing double-digit growth in the small business market. There are a lot of great benefits of having a pension plan with our top 5 described here – and I’m sure that peaks a lot of curiosity to business owners, with tax savings being very appealing! Saving for retirement, and paying less in taxes? Who wouldn’t want to do that?

But how do pension plans actually work?

Pension Plan Definition

What is a pension plan? Investopedia defines a pension plan as “a retirement plan that requires an employer to make contributions to a pool of funds set aside for a worker’s future benefit. The pool of funds is invested on the employee’s behalf, and the earnings on the investments generate income to the worker upon retirement.”

If contributions are required and are invested into a pooled account, this generally means we’re talking about a defined benefit plan, NOT a 401(k) plan or IRA. These plans are very different, and the differences are described here.

Let’s break down Investopedia’s definition, to get to the root of how pension plans work.

“Future Benefit”

A pension plan defines a guaranteed benefit for an employee (including the owner) at retirement, regardless of the investment performance in the pension trust. There’s many different ways to define the benefit, including providing a percent of pay for each year of service, a flat amount for each year of service worked, or an account that increases with defined contributions and interest. Regardless of HOW the benefit is defined, all pension plans will have a formula to determine a monthly amount payable at retirement, and as long as the employee works until retirement, they are guaranteed to receive that amount.

The best-known pension plan is Social Security. Based on your income and the number of years that you work, the Social Security Administration promises to pay you a full benefit at a particular retirement age. That’s exactly what we’re talking about. The business owner decides on what type of formula to use, which may vary based on objective criteria (location, job class, etc).

Required Contributions, and Earnings on Investments Generate Income

Contributions to the plan are paid by the business, and as long as the plan is qualified under ERISA and IRS rules, the amounts are fully deductible from the business’s tax returns.

There is a contribution range that is provided each year, with a minimum required amount and a maximum deductible amount, and the employer must contribute an amount within that range. The range is initially determined by the benefit formula, and considers what the employer should contribute each year in order to be able to pay the benefits in the future. A moderate rate of return, generally 1-5%, is assumed on the invested contributions in the future.

After year 1, the contribution range changes based on the amount of the contributions made, and the actual investment performance. If the employer chooses to contribute the maximum amount in a given year, they have pre-funded the benefits, and will be required to contribute less in the future.

Similarly, contributing the minimum required amounts every year will result in the fund being behind in payments, and will result in higher required payments down the road.

Similarly, if investments are assumed to earn 5%, and they earn 10%, there’s more in the fund than expected, which means the business needs to contribute less.

The bottom line is that the participants are promised their benefits in the future, and will be paid by business contributions and investment earnings. Contributing more up front, or earning more than expected, means the money in the trust is higher than expected, so less needs to go in later.

Pool of Funds

Unlike 401(k) plans, or IRAs, a pension plan does not have individual accounts earmarked for each participant. Contributions are made to a pension trust, which is one pooled account for all participants.

This isn’t to say that each participant’s benefit amount isn’t tracked –the participants receive a statement each year of what their benefit amount is today, as well as what it’s expected to be in the future. Then, each year, a pension actuary compares the benefits due for all of the participants to the amount of money in the pension trust. This is the basis for the contribution range described above.

FAQs

With pension plans, there are a lot of questions asked by business owners and employees alike. We’ve covered some of the more common questions below – if you have other questions, feel free to email us and we’ll get you an answer!

1. How Do I Qualify For The Plan?

The plan document will state what the eligibility requirements are. In general, an employee needs to be over age 21 and worked full time for at least a year. “Full Time” means 1,000 hours per year or more in the pension plan world.

The business owner can always make those requirements less strict – for example, allowing employees under the age of 21 into the plan, or reducing the one-year requirement; it’s up to them as the sponsor how rigid (or not) to make the plan participation requirements.

2. What Happens When a Participant Quits?

Pension plans usually have vesting provisions, which defines the amount of time an employee has to work in order to receive their full benefit amount. For example, 5-year cliff vesting requires an employee to work full-time (over 1,000 hours) for 5 years in order to receive 100% of their benefit. If they don’t, they receive nothing.

If an employee is not vested in a benefit, nothing is paid out from the plan, and any contributions made on behalf of that employee pre-pay the benefits for the others.

If an employees is vested in all, or a portion of their benefit, their final benefit is calculated, and they will receive paperwork from the Third Party Administrator that provides them with distribution options available to them. Most small to mid-size plans allow their participants to roll their benefit out of the plan and into a qualified IRA. In the following year, the participant’s benefit amounts, as well as the money transferred out, are no longer in the calculations.

Learn more about distributions from qualified plans in Episode D of our Retirement A to Z podcast series.

3. Can Employees Contribute To a Pension Plan?

There are very few pension plans that allow employee contributions – all contributions are made by the employer. Some union plans in the past allowed employees to contribute, but it is very uncommon today.

4. What Retirement Age is Used, if The Benefit is Paid At Retirement Age?

Generally, retirement ages are assumed to be between ages 62 and 65.

5. Can the Employer Take Away My Benefits?

No, there are anti-cutback rules from the IRS that doesn’t allow an employer to reduce benefits. Employers are allowed to change the plan so that benefits stay constant and don’t increase in the future, but Internal Revenue Code Section 411(d)(6) specifically prohibits employers from reducing benefits.

6. Can The Employer Take Money Out Of The Pension Trust?

Yes, but the penalties are severe. The pension trust exists for the sole interest of the participants, and contributions made into the fund are not considered business assets any more. The trust even has it’s own Trust ID, to keep the money separate from the business accounts.

If the business does take money out, there is a 50% excise tax, and the amount is immediately counted as income to the business and is taxed accordingly, resulting in the business receiving 10 cents on the dollar.

7. What if The Business Doesn’t Want The Plan Any More? Do I Lose Everything?

If the business owner decides to stop sponsoring the plan, the plan is ‘terminated’. Benefits are calculated as of the termination date, and all of the plan participants are immediately 100% vested in that benefit, no matter how long they’ve worked. The pension trust is then paid out to the participants – first to the employees, and then to the owners – and once all the payments are made and the paperwork is complete, the plan doesn’t exist any more.

8. How Much Will it Cost?

Your cost each year is (1) your contribution to the plan, plus (2) any administration costs, plus potentially (3) PBGC fees. The PBGC is essentially insurance for pension plans; if the business that sponsors the plan goes bankrupt, the PBGC will take over the plan and pay the benefits. Some businesses are exempt from PBGC premiums, so you’ll want to check on this.

That provides you with the gist of how pension plans work. There are a lot of regulations and details with pension plans, but don’t worry, you aren’t expected to learn all of that! You’ll have an administrator who will help you file paperwork, keep track of deadlines, and provide you with your contribution range each year.

Monarch Financial Advisors

There are many other benefits of a pension plan for a business owner, and there are also many types of plans that are available. Pension plans can be designed specifically for your goals and objectives, with contributions in a range that is comfortable for you and your business. Proposals are done at no cost, and confidential information is not required – if you think a pension plan may be right for you, contact us! Our team is ready to answer your questions, and start planning for your future!