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Pension

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A pension is a steady income given to a person (usually after retirement). Pensions are typically payments made in the form of a guaranteed annuity to a retired or disabled employee. Some retirement plan (or superannuation) designs accumulate a cash balance (through a variety of mechanisms) that a retiree can draw upon at retirement, rather than promising annuity payments. These are often also called pensions. In either case, 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 sponsor pension provision.

Occupational pensions are a form of deferred compensation, usually advantageous to employee and employer for tax reasons. Many pensions also contain an insurance aspect, since they often will pay benefits to survivors or disabled beneficiaries, while annuity income insures against the risk of longevity.

While 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.

Types of pensions

Retirement, pension or superannuation plan

By such an arrangement an employer (for example, a corporation, labor union, government agency) provides income to its employees after retirement. Pension plans are a form of "deferred compensation" and became popular in the United States during World War II, when wage freezes prohibited outright increases in workers' pay.

Pension plans can be divided into two broad types: Defined Benefit and Defined Contribution plans. The defined benefit plan had been the most popular and common type of pension plan in the United States through the 1980s; since that time, defined contribution plans have become the more common type of retirement plan in the United States and many other western countries.

Some plan designs combine characteristics of defined benefit and defined contribution types, and are often known 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

Under 26 U.S.C. § 414(j), a defined benefit plan is any pension plan that is not a defined contribution plan (see below). 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.

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 flat dollar plan design that provides $100 per month for every year an employee works for a company; with 30 years of employment, that participant would receive $3,000 per month payable for their lifetime. Typical plans in the United States are final average plans where the average salary over the last three or five years of an employees' career determines the pension; in the United Kingdom, benefits are often indexed for inflation. Formulas can also integrate with public Social security plan provisions and provide incentives for early retirement (or continued work).

Traditional defined benefit plan designs (because of their typically flat accrual rate and the decreasing time for interest discounting as people get closer to retirement age) tend to exhibit a J-shaped accrual pattern of benefits, where the present value of benefits grows quite slowly early in an employees' career and accelerates significantly in mid-career. Defined benefit pensions tend to be less portable than defined contribution plans even if the plan allows a lump sum cash benefit at termination due to the difficulty of valuing the transfer value. On the other hand, defined benefit plans typically pay their benefits as an annuity, so retirees do not bear the investment risk of low returns on contributions or of outliving their retirement income. The open ended nature of this risk to the employer is the reason given by many employers for switching from defined benefit to defined contribution plans.

Because of the J-shaped accrual rate, the cost of a defined benefit plan is very low for a young workforce, but extremely high for an older workforce. This age bias, the difficulty of portability and open ended risk, makes defined benefit plans better suited to large employers with less mobile workforces, such as the public sector.

Defined benefit plans are also criticized as being paternalistic as they require employers or plan trustees to make decisions about the type of benefits and family structures and lifestyles of their employees.

The United States Social Security system is similar to a defined benefit pension arrangement, albeit one that is constructed differently than a pension offered by a private employer.

The "cost" of a defined benefit plan is not easily calculated, and requires an actuary or actuarial software. However, even with the best of tools, the cost of a defined benefit plan will always be an estimate based on economic and financial assumptions. These assumptions include the average retirement age and life span of the employees, the returns earned by the pension plan's investments and any additional taxes or levies, such as those required by the Pension Benefit Guaranty Corporation in the U.S. So, for this arrangement, the benefit is known but the contribution is unknown even when calculated by a professional.

Defined contribution plans

In the United States, the legal definition of a defined contribution plan is a plan providing for an individual account for each participant, and for benefits based solely on the amount contributed to the account, plus or minus income, gains, expenses and losses allocated to the account (see 26 U.S.C. § 414(i)). Plan contributions are paid into an individual account for each member. The contributions are invested, for example in the stock market, and the returns on the investment (which may be positive or negative) are credited to the individual's account. On retirement, the member's account is used to provide retirement benefits, often through the purchase of an annuity which provides a regular income. Defined contribution plans have become more widespread all over the world in recent years, and are now the dominant form of plan in the private sector in many countries. For example, the number of defined benefit plans in the US has been steadily declining, as more and more employers see the large pension contributions as a large expense that they can avoid by disbanding the plan and instead offering a defined contribution plan.

Examples of defined contribution plans in the United States include Individual Retirement Accounts (IRAs) and 401(k) plans. In such plans, the employee is responsible, to one degree or another, for selecting the types of investments toward which the funds in the retirement plan are allocated. This may range from choosing one of a small number of pre-determined mutual funds to selecting individual stocks or other securities. Most self-directed retirement plans are characterized by certain tax advantages, and some provide for a portion of the employee's contributions to be matched by the employer. In exchange, the funds in such plans may not be withdrawn by the investor prior to reaching a certain age--typically the year the employee reaches 59.5 years old--(with a small number of exceptions) without incurring a substantial penalty.

Money contributed can either be from employee salary deferral or from employer contributions or matching. Defined contribution plans are subject to IRS limits on how much can be contributed, known as the section 415 limit. The total deferral amount including the employee and employer contribution is the lesser of $40,000 or 100% of compensation. The employee only amount is $15,000 for 2006 with a $5,000 catch up. These numbers continue to be increased each year and are indexed to compensate for the effects of inflation. The portability of defined contribution pensions is legally no different from the portability of defined benefit plans. However, because of the cost of administration and ease of determining the plan sponsor's liability for defined contribution plans (you don't need to pay a actuary to calculate the lump sum equivalent under Section 417(e) that you do for defined benefit plans) in practice, defined contribution plans have become generally portable.

In a defined contribution plan, investment risk and investment rewards are assumed by each individual/employee/retiree and not by the sponsor/employer. In addition, participants do not typically purchase annuities with their savings upon retirement, and bear the risk of outliving their assets.

The "cost" of a defined contribution plan is readily calculated, but the benefit from a defined contribution plan depends upon the account balance at the time an employee is looking to use the assets. So, for this arrangement, the contribution is known but the benefit is unknown (until calculated).

Despite the fact that the participant in a defined contribution plan typically has control over investment decisions, the plan sponsor retains a significant degree of fiduciary responsibility over investment of plan assets, including the selection of investment options and administrative providers.

Hybrid and cash balance plans

Hybrid plan designs combine the features of defined benefit and defined contribution plan designs. In general, they are usually treated as defined benefit plans for tax, accounting and regulatory purposes. As with defined benefit plans, investment risk in hybrid designs is largely borne by the plan sponsor. As with defined contribution designs, plan benefits are expressed in the terms of a notional account balance, and are usually paid as cash balances upon termination of employment. These features make them more portable than traditional defined benefit plans and perhaps more attractive to a more highly mobile workforce. A typical hybrid design is the Cash Balance Plan, where the employee's notional account balance grows by some defined rate of interest and annual employer contribution.

Financing

There are various ways in which a pension may be financed.

Funded status

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. It has been suggested that this model bears a disturbing resemblance to a Ponzi scheme.

In a funded defined benefit arrangement, an actuary calculates the contributions that the plan sponsor must make 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 the United States, 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, provide timely and uninterrupted payment of pension benefits.

Defined contribution pensions, by definition, are funded, as the "guarantee" made to employees is that specified (defined) contributions will be made during an individual's working life.

Local or universal plans

Because any dollar of savings by any one person in the economy means a dollar of borrowing by another person (all financial assets in the economy net to zero at all times, but real assets do not), any universal system of pensions cannot save in the conventional way. Therefore, if the United States were a true autarkic economy, then any universal pension system must be pay as you go because the food, clothes and services that someone aged 25 year today would need in 40 years would be when he is age 65 would be produced 40 years later. Storing money or financial assets today represents current claims on current production. But a system of prefunding would enable the accounting of such a system to work, given that real savings in the form of capital investments would have made the economy more productive in the future.

However, once we release the assumption of universality by say allowing for foreign investments -- the average age in Mexico is under 16 -- we can perform some pre-funding. The extent of possible pre-funding could be gagged by the current account or trade deficit or surplus.

Current challenges

A growing challenge for many nations is population ageing. As birth rates drop and life expectancy increases an ever-larger portion of the population is elderly. This leaves fewer workers for each retired person. In almost all developed countries this means that government and public sector pensions could collapse their economies unless pension systems are reformed or taxes are increased. One method of reforming the pension system is to increase the retirement age. Two exceptions are Australia and Canada, where the pension system is forecast to be solvent for the foreseeable future. In Canada, for instance, the annual payments were increased by some 70% in 1998 to achieve this. These two nations also have an advantage from their relative openness to immigration. However, their populations are not growing as fast as the U.S., which supplements a high immigration rate with one of the highest birthrates among Western countries. Thus, the population in the U.S. is not aging to the extent as those in Europe, Australia, or Canada.

Another growing challenge is the recent trend of businesses purposely under-funding their pension schemes in order to push the costs onto the federal government. Bradley Belt, executive director of the PBGC (the Pension Benefit Guaranty Corporation, the federal agency that insures private-sector defined-benefit pension plans in the event of bankruptcy), testified before a congressional hearing in October 2004, “I am particularly concerned with the temptation, and indeed, growing tendency, to use the pension insurance fund as a means to obtain an interest-free and risk-free loan to enable companies to restructure. Unfortunately, the current calculation appears to be that shifting pension liabilities onto other premium payers or potentially taxpayers is the path of least resistance rather than a last resort.”

Pension systems in various countries

Peculiar pension systems for the public sector

The following are examples for Britain, from the 1911 Encyclopedia Britannica

Perpetual or Hereditary Pensions

Perpetual pensions were freely granted either to favorites or as a reward for political services from the time of Charles II onwards. Such pensions were very frequently attached as salaries to places which were sinecures, or, just as often, posts which were really necessary were grossly overpaid, while the duties were discharged by a deputy at a small salary. Prior to the reign of Queen Anne, such pensions and annuities were charged on the hereditary revenues of the sovereign and were held to be binding on the sovereigns successors (The Bankers Case, 1691; State Trials, xiv. 3-43). By I Anne c. 7 it was provided that no portion of the hereditary revenues could be charged with pensions beyond the life of the reigning sovereign. This act did not affect the hereditary revenues of Ireland and Scotland, and many persons were quartered, as they had been before the act, on the Irish and Scottish revenues who could not be provided for in England for example, the duke of St Albans, illegitimate son of Charles II, had an Irish pension of £800 a year; Catherine Sedley, mistress of James II, had an Irish pension of £5000 a year; the duchess of Kendall and the countess of Darlington, mistresses of George I, had pensions of the united annual value of £5000, while Madame de Walmoden, a mistress of George II, had a pension of £3000 (Lecky, History of Ireland in the Eighteenth Century). These pensions had been granted in every conceivable formduring the pleasure of the Crown, for the life of the sovereign, for terms of years, for the life of the grantee, arid for several lives in being or in reversion (Erskine May, Constitutional History of England). On the accession of George III and his surrender of the hereditary revenues in return for a fixed civil list, this civil list became the source from which the pensions were paid. The three pension lists of England, Scotland and Ireland were consolidated in 1830, and the civil pension list reduced to f75,000, the remainder of the pensions being charged on the Consolidated Fund.

In 1887, Charles Bradlaugh, M.P., protested strongly against the payment of perpetual pensions, and as a result a Committee of the House of Commons inquired into the subject (Report of Select Committee on Perpetual Pensions, 248, 1887). An appendix to the Report contains a detailed list of all hereditary pensions, payments and allowances in existence in 1881, with an explanation of the origin in each case and the ground of the original grant; there are also shown the pensions, &c., redeemed from time to time, and the terms upon which the redemption took place. The nature of some of these pensions may be gathered from the following examples: To the duke of Marlborough and his heirs in perpetuity, £4000 per annum; this annuity was redeemed in August 1884 for a sum of £107,780, by the creation of a ten years annuity of £12,796, 17s. per annum. By an act of 1806 an annuity of £5000 per annum was conferred on Lord Nelson and his heirs in perpetuity. In 1793 an annuity of £2000 was conferred on Lord Rodney and his heirs. All these pensions were for Services rendered, and although justifiable from that point of view, a preferable policy is pursued in the 20th century, by parliament voting a lump sum, as in the cases of Lord Kitchener in 1902 (£50,000) and Lord Cromer in 1907 (£50,000). Charles II granted the office of receiver-general and controller of the seals of the court of kings bench and common pleas to the duke of Grafton. This was purchased in 1825 fron the duke for an annuity of £843, which in turn was commuted in 1883 for a sum of £22,714, 12s. 8d. To the same duke was given the office of the pipe or remembrancer of first-fruits and tenths of the clergy. This office was sold by the duke in 1765], and after passing through various hands was purchased by one R. Harrisor in 1798. In 1835 on the loss of certain fees the holder was compensated by a perpetual pension of £62, 9s 8d. The duke of Graftol also possessed an annuity of £6870 in respect of the commutatior of the dues of butlerage and prisage. To the duke of St Alban was granted in 1684 the office of master of the hawks. The sum granted by the original patent were: master of hawks, salary £391. 1s. 5d.; four falconers at £50 per annum each, £200; provision of hawks, £600; provision of pigeons, hens and other meats £182, l0s.; total, £1373. 1?s. 5d. This amount was reduced by office fees and other deductions to £965, at which amount it stood until commuted in 1891 for £f8,335. To the duke of Richmond and his heirs was granted in 1676 a duty of one shilling per ton of all coals exported from the Tyne for consumption in England. This was redeemed in 1799 for an annuity of £19,000 (chargeable on the consolidated fund), which was afterwards redeemed for £633,333. The Duke of Hamilton, as hereditary keeper of the palace of Holyrood House, received a perpetual pension of £45,105. and the descendants of the heritable usher of Scotland drew a salary of £242, l0s. The conclusions of the committee were that pensions allowances and payments should not in future be granted in per pertuity, on the ground that such grants should be limited to thi persons actually rendering the service, and that such reward should be defrayed by the generation benefited; that offices witi salaries and without duties, or with merely nominal duties, ought to be abolished; that all existing perpetual pensions and payments and all hereditary offices should be abolished: that where no service or merely nominal service is rendered by the holder of an hereditary office or the original grantee of a pension, the pension or payment should in no case continue beyond the life of the present holder and that in all cases the method of commutation ought to ensure a real and substantial saving to the nation (the existing rate, about 27 years purchase, being considered by the committee to be too high). These recommendations of the committee were adopted by the government and outstanding hereditary pensions were gradually commuted, the only ones left outstanding being those to Lord Rodney (£2000) and to Earl Nelson (£5ooo), both chargeable on the consolidated fund.

Political pensions

These are type sui generis as they either reward a career in domestic politics or are awarded in the colonial context not on grounds of justice, contract or socio-economic merits, but as a political decision, in order to take a politically significant person (often deemed a potential political danger) out of the picture by paying him or her off, regardless of seniority. See political pensioner.

Civil List Pensions

These are pensions granted by the sovereign from the civil list upon the recommendation of the first lord of the treasury. By I & 2 Vict. c. 2 they are to be granted to such persons only as have just claims on the royal beneficence or who by their personal services to the Crown, or by the performance of duties to the public, or by their useful discoveries in science and attainments in literature and the arts, have merited the gracious consideration of their sovereign and the gratitude of their country. A sum of f12oo is allotted each year from the civil list, in addition to the pensions already in force. From a Return issued in 1908, the total of civil list pensions payable in that year amounted to 24,665.

Judicial, Municipal, &c

There are certain offices of the executive whose pensions are regulated by particular acts of parliament. Judges of the Supreme Court, on completing fifteen years servics or becoming permanently incapacitated for duty, whatever their length of service, may be granted a pension equal to two-thirds ol their salary (Judicature Act 5873). The lord chancellor of England however short a time he may have held office, receives a pension of 45000, but he usually continues to sit as a law lord in the House of Lords so also does the lord chancellor of Ireland, who receives a pension of 3,692 6s. 1d. A considerable number of local author ities have obtained special parliamentary powers for the pur pose of superannuating their officials and workmen who havi reached the age of 6o65. Poor law officers receive superannuation allowances under the Poor Law Officers Superannuation Act 1864-1897.

Ecclesiastical Pensions

(Anglican?) Bishops, deans, canons or incumbent who are incapacitated by age or infirmity from the discharge of their ecclesiastical duties may receive pensions which are a charg upon the revenues of the see or cure vacated.

Royal Navy

Navy pensions were first instituted by William III in 1693 and regularly established by an order in council of Queen Anne in 1700. Since then the rate of pensions has undergone various modification and alterations; the full regulations concerning pensions to all ranks will be found in the quarterly Navy List, published by authority of the Admiralty. In addition to the ordinary pension there are also good-service pensions, Greenwich Hospital pension and pensions for wounds. An officer is entitled to a pension when he is retired at the age of 45, or if he retires between the ages c 40 and 45 at his own request, otherwise he receives only half pay. The amount of his pension depends upon his rank, length of service and age. As an example, in past, the maximum retired pay of an admiral was 850 per annum, for which 30 years service or its equivalent in half-pay time is necessary; he may, in addition, have held a good service pension of 300 per annum. The maximum retired pay of a vice-admiral with 29 years service was 725; of rear-admirals with 27 years service, 600 per annum. Pensions of captains who retire at the age of 55, commanders, who retire at 50, and lieutenants who retire at 45, ranged from 200 per annum for 17 years service to 525 for 24 years service. The pensions of other officers were calculated in the same way, according to age and length of service. The good-service pensions consisted of ten pensions of 300 per annum for flag-officers, two of which may be held by vice-admirals and two by rear-admirals; twelve of 150 for captains; two of 200 a year and two of 150 a year for engineer officers; three of 100 a year for medical officers of the navy; six of 200 a year for general officers of the Royal Marines and two of 150 a year for colonels and lieutenant-colonels of the same. Greenwich Hospital pensions range from 150 a year for flag officers to 25 a year for warrant officers. All seamen and marines who have completed twenty-two years service are entitled to pensions ranging from 1 od. a day to a maximum of Is. 2d. a day, according to the number of good-conduct badges, together with the good-conduct medal, possessed. Petty officers, in addition to the rates of pension allowed them as seamen, are allowed for each years service in the capacity of superior petty officer, I5s. 2d. a year, and in the capacity of inferior petty officer 7s. 7d. a year. Men who are discharged from the service on account of injuries and wounds or disability attributable to the service are pensioned with sums varying from 6d. a day to 2s. a day. Pensions are also given to the widows of officers in certain circumstances and compassionate allowances made to the children of officers. In the Navy estimates for 1908-1909 the amount required for halfpay and retired-pay was 868,800, and for pensions, gratuities and compassionate allowances 1,334,600, a total of 2,203,400.

Army

The system of pensions in the British Army is somewhat intricate, provision being made for dealing with almost every case separately. (details not included here)

See also

Agencies

Nonprofit Groups

Research on Pensions

Articles

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