Retirement Plans

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Retirement Plans

What It Means

A retirement plan is a financial arrangement that provides a person with income when they retire. Workers in the United States and many other developed countries typically retire from work at or around age 65. After they retire and no longer receive a salary, the retirement plans in which they are enrolled provide them with the money they need to maintain their standard of living.

Retirement plans are usually set up by the past employer of the person retiring, although insurance companies, government agencies, and trade unions may also set up plans. The money the retirement plan pays to the retiree comes out of a fund to which the retiree, when he or she was employed, regularly contributed. Usually the employer takes the contributed amount out of each paycheck an employee receives and puts it into an investment product such as stock. Whether the investment gains or loses money, it is saved in the retirement account until the time the employee stops working, and then it is paid out to the employee. The payments that the retirement plan owes the employee are called the benefits.

A retirement plan that guarantees a participating employee a specific monthly benefit at the time of retirement is called a defined benefit plan. These benefits typically continue until the former employee, and often the spouse, dies. This type of plan may provide a specified amount of money each month, which is usually dependent on the participant’s salary level and how many years he or she has belonged to the plan. In general, the participant does not make decisions about how money is invested; the institution managing the retirement plan takes care of all investment decisions. With many plans the employer as well as the employee contributes money to the plan. Defined benefit plans are sometimes called fully funded pension plans.

A retirement plan that provides an individual account for each participant and bases the benefit on the amount of money contributed as well as on the performance of the investments is called a defined contribution plan. These amount of the benefit paid out is less predictable than it is in a defined retirement plan. Also, the employee, not the institution, takes on the investment risk. Some examples of defined contribution plans are 401(k) plans, 403(b) plans, employee stock-ownership plans, and profit-sharing plans.

Most retirement plans are either defined benefit plans or defined contribution plans, but some retirement plans, called hybrid plans, combine features of both defined benefit and defined contribution plans.

When Did It Begin

Up until the 1870s, most businesses in the United States were small, family-run enterprises that did not have formal plans for providing money to employees after they retired. Most Americans were still working as farmers, and it was more typical for older Americans to stay involved in work in old age, providing guidance to younger workers even if they did not have stamina or high rates of productivity. In 1875 the American Express Company established the first private pension plan in the United States.

Between 1875 and 1929 private-sector pension plans gradually grew more popular in the United States and Canada. Some of the major U.S. companies to establish plans in this period were Standard Oil of New Jersey, U.S. Steel Corporation, General Electric Co., American Telephone and Telegraph Co., Goodyear Tire and Rubber Co., and Eastman Kodak Co. By 1940, 4.1 million private-sector workers (15 percent of all private-sector workers) were covered by pension plans.

In 1935 President Roosevelt signed the Social Security Act, a federally sponsored social insurance program that provided benefits to retirees and the unemployed and a lump-sum benefit at death. The government raised money for this program by imposing a tax on workers’ wages. Social Security did not guarantee financial security for retirees, and so the introduction of the program did not radically affect the trend of older workers putting off retirement until they could not physically manage work anymore. Even through the 1950s, the concept of retirement had not become widespread.

In the 1940s the large American automaker General Motors was chaired by Charles Erwin Wilson (1890–1961). Wilson designed GM’s first modern pension fund, which was distinct from other pension plans because it allowed employed to choose to invest in all publicly traded stocks, not just GM stocks. By 1990, 39.5 million private-sector workers (43 percent of all such workers) were covered by a pension plan.

More Detailed Information

In the United States individuals who follow a common pattern of working until they reach their 60s or 70s usually retire and begin to live on income from their savings account, the government’s Social Security program, or a retirement plan such as an IRA (or a combination of the three). There are many different types of retirement plans and a variety of different tax laws and regulations that apply to them.

A defined benefit plan provides employees with retirement benefits that are predetermined by such things as their salary, the number of years they have worked at an organization, and their age when they retire. This type of plan may be funded, meaning that the employer has also contributed to the investment fund. Most defined benefit plans are funded because the governments in many countries, including the United States, the United Kingdom, and Australia, encourage them by providing tax incentives if individuals and businesses contribute to them. A defined benefit plan may also be unfunded plan, meaning that neither the employee nor the employer sets funds aside on a regular basis. The benefits for these plans come out of taxes and the contributions of current workers, as in the case of the Social Security system in the United States. The participant in a defined benefit plan does not need to demonstrate an ability to save money in order to receive the benefit of such a plan.

A defined contribution plan gives the employee the responsibility of choosing the types of investments to use, ranging from mutual funds to individual stocks to securities. Some of these plans give the employer the ability to contribute a matching dollar amount to the employee’s contributions. These plans usually restrict the participant from taking funds out of the plan before they reach a certain age (typically 59.5 years old) without being charged a penalty.

Defined contribution plans that are commonly used include 401(k) plans, Individual Retirement Accounts (IRAs), Keogh Plans, and profit-sharing plans.

The 401(k) plan, sometimes called a salary-reduction plan, is a retirement plan that is provided to employees at most large companies and many small ones. Employees can contribute to the 401(k) plan by having a designated amount of pretax dollars deducted from their paychecks. The employee is usually allowed to select from a variety of investment choices. These choices consist of different mutual funds that emphasize stocks, bonds, and money market investments. Employers generally match part of the employee’s contribution, giving employees an incentive to save more money for retirement. The employee pays no taxes until he or she begins to withdraw money, which he or she must do between the ages of 59.5 and 70.5.

An IRA is a retirement account that allows an individual to set aside money each year until withdrawals begin at age 59.5 or later. IRA plans are tax-deferred plans, meaning that payment of some or all of the taxes are deferred, or put off, until a future date, rather than in the year the investment creates income. In contrast to a 401(k) plan, an IRA is funded entirely by the individual taxpayer.

A Keogh Plan is a retirement plan similar to the 401(k) and IRA, but it is for workers who are either self-employed or employed by unincorporated businesses. The Keogh Plan is also known as HR 10, and as with the IRA, the earnings from its investments are tax-deferred until the capital is taken out of the plan by the retiree, which he or she must do between the ages of 59.5 and 70.5 or take a 10 percent penalty. Usually people who use Keogh Plans invest their money in combinations of stocks, bonds, money market funds, and mutual funds.

A profit-sharing plan is one that provides employees with a portion of the profits of the company. There is no requirement for the company to contribute to the plan; it can also decide what portion of the profit will be shared and may make profit-sharing contributions whether or not the business was profitable for a given year. When instituted, each employee receives a percentage of profits based on the company’s earnings, an arrangement that commonly gives them a strong sense of ownership in the company.

A 403(b) plan, also called a tax-sheltered annuity plan, is similar to a 401(k) plan, but it is offered by nonprofit organizations, such as public schools, universities, and charitable organizations, rather than corporations. A 403(b) plan can take the form of an annuity contract, which is a program provided by an insurance company. It can also take the form of a custodial account, which invests the contributions into mutual funds. Finally, it can be a retirement-income account that is established for church employees. The contributions to the 403(b) plan are not taxed until the employee begins to withdraw from the plan, which usually happens after retirement.

Recent Trends

Defined benefit retirement plans became popular in the years following World War II (1939–45). By the late 1970s approximately 62 percent of all active workers in the United States were covered exclusively by defined benefit plans, according to the Employee Benefit Research Institute. After this peak, employer participation in these plans gradually declined, and by 1997 only 13 percent of employees had a pension plan as their sole retirement benefit. As defined benefit plans have waned in popularity, defined contribution plans have grown in popularity. The amount of active workers with a defined contribution plan and no pension was 16 percent in 1979, but by 2004 that figure had increased to 62 percent.

At the same time that more people have become covered by defined contribution plans, a series of bankruptcies in large corporate industries such as steel, airlines, and auto parts has had the effect of shifting the burden of retirement management to employees. Many of the baby boomers (people born between 1946 and 1964) have witnessed a reduction in stable sources of retirement income in the late twentieth and early twenty-first centuries. At the same time, average life expectancy has increased steadily, which means retirees need to spread their retirement incomes out over more time, on average, than previous generations of retirees.

These factors, in addition to low participation rates in 401(k)s, pre-retirement 401(k) withdrawals, and low rates of savings in general, have meant that more than almost three-quarters of working-age households are at risk of seeing their standard of living decline in retirement, according to the Center for Retirement Research. Social Security only replaces approximately a third of pre-retirement income for the average earner retiring at age 62.