A pension is a fixed sum paid regularly to a person, typically following retirement from service. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.
The terms retirement plan and superannuation refer to a pension granted upon retirement. Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Called retirement plans in the United States, they are commonly known as pension schemes in theUnited Kingdom and Ireland and superannuation plans (or super) in Australia and New Zealand. Retirement pensions are typically in the form of a guaranteed life annuity, thus insuring against the risk of longevity.
A pension created by an employer for the benefit of an employee is commonly referred to as an occupational or employer pension. Labor unions, the government, or other organizations may also fund pensions. Occupational pensions are a form of deferred compensation, usually advantageous to employee and employer for tax reasons. Many pensions also contain an additional insurance aspect, since they often will pay benefits to survivors or disabled beneficiaries. Other vehicles (certain lottery payouts, for example, or an annuity) may provide a similar stream of payments.
The common use of the term pension is to describe the payments a person receives upon retirement, usually under pre-determined legal and/or contractual terms. A recipient of a retirement pension is known as a pensioner or retiree.
Types of pensions
Employment-based pensions (retirement plans)
A retirement plan is an arrangement to provide people with an income during retirement when they are no longer earning a steady income from employment. Often retirement plans require both the employer and employee to contribute money to a fund during their employment in order to receive defined benefits upon retirement. It is a tax deferred savings vehicle that allows for the tax-free accumulation of a fund for later use as a retirement income. Funding can be provided in other ways, such as from labor unions, government agencies, or self-funded schemes. Pension plans are therefore a form of “deferred compensation”. A SSASis a type of employment-based Pension in the UK.
Social and state pensions
Many countries have created funds for their citizens and residents to provide income when they retire (or in some cases become disabled). Typically this requires payments throughout the citizen’s working life in order to qualify for benefits later on. A basic state pension is a “contribution based” benefit, and depends on an individual’s contribution history. For examples, see National Insurance in the UK, or Social Security in the USA.
Many countries have also put in place a “social pension“. These are regular, tax-funded non-contributory cash transfers paid to older people. Over 80 countries have social pensions. Examples are the Old Age Grant in South Africa and the Universal Superannuation scheme in New Zealand.
Some pension plans will provide for members in the event they suffer a disability. This may take the form of early entry into a retirement plan for a disabled member below the normal retirement age.
Retirement plans may be classified as defined benefit or defined contribution according to how the benefits are determined. A defined benefit plan guarantees a certain payout at retirement, according to a fixed formula which usually depends on the member’s salary and the number of years’ membership in the plan. A defined contribution plan will provide a payout at retirement that is dependent upon the amount of money contributed and the performance of the investment vehicles utilized.
Some types of retirement plans, such as cash balance plans, combine features of both defined benefit and defined contribution plans. They are often referred to as hybrid plans. Such plan designs have become increasingly popular in the US since the 1990s. Examples include Cash Balance and Pension Equity plans.
Defined benefit plans
A traditional defined benefit (DB) plan is a plan in which the benefit on retirement is determined by a set formula, rather than depending on investment returns. In the US,specifies a defined benefit plan to be any pension plan that is not a defined contribution plan (see below) where a defined contribution plan is any plan with individual accounts. A traditional pension plan that defines a benefit for an employee upon that employee’s retirement is a defined benefit plan.
Traditionally, retirement plans have been administered by institutions which exist specifically for that purpose, by large businesses, or, for government workers, by the government itself. A traditional form of defined benefit plan is the final salary plan, under which the pension paid is equal to the number of years worked, multiplied by the member’s salary at retirement, multiplied by a factor known as the accrual rate. The final accrued amount is available as a monthly pension or a lump sum, but usually monthly.
The benefit in a defined benefit pension plan is determined by a formula that can incorporate the employee’s pay, years of employment, age at retirement, and other factors. A simple example is a Dollars Times Service plan design that provides a certain amount per month based on the time an employee works for a company. For example, a plan offering $100 a month per year of service would provide $3,000 per month to a retiree with 30 years of service. While this type of plan is popular among unionized workers, Final Average Pay (FAP) remains the most common type of defined benefit plan offered in the United States. In FAP plans, the average salary over the final years of an employee’s career determines the benefit amount.
Averaging salary over a number of years means that the calculation is averaging different dollars. For example, if salary is averaged over five years, and retirement is in 2009, then salary in 2004 dollars is averaged with salary in 2005 dollars, etc., with 2004 dollars being worth more than the dollars of succeeding years. The pension is then paid in first year of retirement dollars, in this example 2009 dollars, with the lowest value of any dollars in the calculation. Thus inflation in the salary averaging years has a considerable impact on purchasing power and cost, both being reduced equally by inflation
This effect of inflation can be eliminated by converting salaries in the averaging years to first year of retirement dollars, and then averaging.
In the United Kingdom, benefits are typically indexed for inflation (known as Retail Prices Index (RPI)) as required by law for registered pension plans. Inflation during an employee’s retirement affects the purchasing power of the pension; the higher the inflation rate, the lower the purchasing power of a fixed annual pension. This effect can be mitigated by providing annual increases to the pension at the rate of inflation (usually capped, for instance at 5% in any given year). This method is advantageous for the employee since it stabilizes the purchasing power of pensions to some extent.
If the pension plan allows for early retirement, payments are often reduced to recognize that the retirees will receive the payouts for longer periods of time. In the United States, under the Employee Retirement Income Security Act of 1974, any reduction factor less than or equal to the actuarial early retirement reduction factor is acceptable.
Many DB plans include early retirement provisions to encourage employees to retire early, before the attainment of normal retirement age (usually age 65). Companies would rather hire younger employees at lower wages. Some of those provisions come in the form of additional temporary or supplemental benefits, which are payable to a certain age, usually before attaining normal retirement age.
Defined benefit plans may be either funded or unfunded.
In an unfunded defined benefit pension, no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid. Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly from current workers’ contributions and taxes. This method of financing is known as Pay-as-you-go (PAYGO or PAYG). The social security systems of many European countries are unfunded, having benefits paid directly out of current taxes and social security contributions, although several countries have hybrid systems which are partially funded. Spain set up the Social Security Reserve Fund and France set up the Pensions Reserve Fund; in Canada the wage-based retirement plan (CPP) is funded, with assets managed by the CPP Investment Board while the U.S. Social Security system is funded by investment in special U.S. Treasury Bonds.
In a funded plan, contributions from the employer, and sometimes also from plan members, are invested in a fund towards meeting the benefits. The future returns on the investments, and the future benefits to be paid, are not known in advance, so there is no guarantee that a given level of contributions will be enough to meet the benefits. Typically, the contributions to be paid are regularly reviewed in a valuation of the plan’s assets and liabilities, carried out by anactuary to ensure that the pension fund will meet future payment obligations. This means that in a defined benefit pension, investment risk and investment rewards are typically assumed by the sponsor/employer and not by the individual. If a plan is not well-funded, the plan sponsor may not have the financial resources to continue funding the plan. In many countries, such as the USA, the UK and Australia, most private defined benefit plans are funded, because governments there provide tax incentives to funded plans (in Australia they are mandatory). In the United States, non-church-based private employers must pay an insurance-type premium to the Pension Benefit Guaranty Corporation, a government agency whose role is to encourage the continuation and maintenance of voluntary private pension plans and provide timely and uninterrupted payment of pension benefits.
Adverse impact of low interest rates
World Pensions Council (WPC) Financial economists have argued that durably low interest rates in most G20 countries will have an adverse impact on the underfunding condition of pension funds as “without returns that outstrip inflation, pension investors face the real value of their savings declining rather than ratcheting up over the next few years”  From 1982 until 2011, most Western economies experienced a period of low inflation combined with relatively high returns on investments across all asset classes including government bonds. This brought a certain sense of complacency amongst some pension actuarialconsultants and regulators, making it seem reasonable to use optimistic economic assumptions to calculate the present value of future pension liabilities. The potentially long-lasting collapse in returns on government bonds is taking place against the backdrop of a protracted fall in returns for other core-assets such as blue chip stocks, and, more importantly, a silent demographic shock. Factoring in the corresponding “longevity risk”, pension premiums could be raised significantly while disposable incomes stagnate and employees work longer years before retiring.