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Savings Plans
Part 1: What Types of Retirement Savings Plans Are Available?
In today's retirement plan arena, there are two major types of retirement plans offered by employers. These are
defined benefit and defined contribution, which are described here and outlined
in Table 1. Keep in mind that your employer may have more than one type of plan,
and may have different participation requirements for each.
Although rare today, a defined benefit plan promises you a specific monthly
benefit at retirement. These plans are funded by the employer for the employee. The plan may state this promised benefit as an exact
dollar amount, such as $100 per month at retirement. Or, more often, it may
calculate your benefit through a formula that includes factors such as your
salary, your age, and the number of years you worked at the company. For
example, your pension benefit might be equal to 1 percent of your average salary
for the last 5 years of employment times your total years of service.
A defined contribution plan does not promise you a specific
benefit amount at retirement. Defined contrubution plans are funded mainly by employees. However, both you and/or your employer contribute money when the employer offers a contribution
to your individual account in the plan. In many cases, you are responsible for
choosing how these contributions are invested, and deciding how much to
contribute from your paycheck through pretax deductions. Your employer may add
to your account, in some cases by matching a certain percentage of your
contributions. The value of your account depends on how much is contributed and
how well the investments perform. At retirement, you receive the balance in your
account, reflecting the contributions, investment gains or losses, and any fees
charged against your account. The 401k plan is a popular type of defined
contribution plan, and there are three types of 401k plans: traditional,
SIMPLE 401k, and
Safe Harbor 401k plans. The
SIMPLE IRA plan, SEP, Employee Stock Ownership Plan (ESOP),
and profit-sharing plan are other examples of defined contribution plans. (See
explanations of the various types of plans in the Glossary at the end).
Note
Federal
law does not require employers to offer or to continue to offer a retirement plan.
The Pension Benefit Guaranty Corporation (PBGC)
guarantees payment of certain retirement benefits for participants in most
private defined benefit plans if the plan is terminated without enough money to
pay all of the promised benefits. The government does not guarantee benefit
payments for defined contribution plans. For more information, see the PBGC’s
Web site.
Some hybrid plans - such as cash balance plans - contain features of both
types of plans described above. See the Glossary for information on this type of
plan.
Table 1 - Characteristics Of Defined Benefit And Defined Contribution Plans
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Defined Benefit plan |
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Defined Contribution Plan |
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Employer Contributions and/or Matching Contributions |
Employer funded. Federal rules set amounts that employers
must contribute to plans in an effort to ensure that plans have enough money to
pay benefits when due. There are penalties for failing to meet these
requirements. |
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There is no requirement that the employer contribute to retirement plans of employees, except
in the SIMPLE 401k and Safe Harbor 401ks, money purchase plans, SIMPLE IRA and
SEP plans.
The employer may choose to match a portion of the employee’s contributions or to
contribute without employee contributions. In some plans, employer contributions
may be in the form of employer stock.
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Employee Contributions |
Generally, employees do not contribute to these plans.
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Many plans require the employee to contribute in order for
an account to be established.
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Managing Your Retirement Investments |
Retirement plan officials manage the actual plan investments, and the employer is
responsible for ensuring that the amount it has put in the plan and that investment
earnings will be enough to pay the promised benefit. |
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The employee often is responsible for managing the
investment of his or her account, choosing from investment options offered by
the plan. In some plans, plan officials are responsible for investing all the
plan’s assets.
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Benefit Amounts Received Upon Retirement |
A promised benefit is based on a formula in the plan, often
using a combination of the employee’s age, years worked for the employer, and/or
salary. |
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The benefit depends on contributions made by the employee
and/or the employer, performance of the account’s investments, and fees charged
to the account.
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| Benefit Payments Types |
Traditionally, these plans pay the retiree monthly annuity
payments that continue for life. Plans may offer other payment options. |
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The retiree may transfer the account balance into an
individual retirement account (IRA) from which the retiree withdraws money, or
may receive it as a lump sum payment. Some plans also offer monthly payments
through an annuity.
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Retirement Benefit Guarantees |
The Federal government, through the Pension Benefit Guaranty
Corporation (PBGC), guarantees some amount of benefits.
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No Federal guarantee of benefits. |
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If You Leave the Company Before Retirement Age |
If an employee leaves after vesting in a benefit but before
the plan’s retirement age, the benefit generally stays with the plan until the
employee files a claim for it at retirement. Some defined benefit plans offer
early retirement options. |
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The employee may transfer the account balance to an
individual retirement account (IRA) or, in some cases, another employer plan,
where it can continue to grow based on investment earnings. The employee also
may take the balance out of the plan, but will owe taxes and possibly penalties,
thus reducing retirement income. Plans may cash out small accounts.
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