What is Foolsaurus?

It's a glossary of investing terms edited and maintained by our analysts, writers and YOU, our Foolish community. Get Started Now!


Pension

A pension is a company-provided benefit paying a monthly amount to employees after they retire. Fewer and fewer companies are offering pensions, and if a company hits hard times, there's no guarantee retirees will get the full pensions they were promised.

Contents

Defined Benefit Plans

Defined benefit plans usually are based on a formula that considers years of service and often your age. These formulas reward employees with long years of service with better pensions. In effect, the formula is inflation protected as long as you work for the company. The benefit is usually defined by your salary in the final years of employment. Defined contribution plans usually pay a percentage of wages when paid. Hence, it is up to the employee to manage investments to cover inflation. The employee rather than the employer takes the risk.

Companies dislike defined benefit pension plans in part because changes in the market value of investments in their pension fund cause their liability to change with the stock market. In some years, the market does well and their plan is overfunded, sometimes even throwing off profits that go to the bottom line as earnings. Other years, the market is down and the company finds its plan massively underfunded. Especially for those companies who are rewarded for growing earnings in an orderly well planned way, the uncertainty introduced by the pension plan can be a pain. They prefer a defined contribution plan where their pension expense is well defined. Competition for the best employees is the main reason defined benefit plans continue to exist.

Another concern with defined benefit plans is the cost of the plan to the employer varies with age. Young employees, far from retirement, are inexpensive in terms of the contribution required to fund their pension plan. But costs rise as the employee approaches retirement age. Hence, defined benefit plans tend to work against older employees. The numbers encourage managers to hire younger workers.


PBGC Protection

The AFL-CIO estimates 86% of union workers and 51% of nonunion workers participate in pension plans. It also relates the story of a retired steelworker whose former employer declared bankruptcy, leaving it to the federal Pension Benefit Guaranty Corp. to fund the pension. The PBGC cut the workers' monthly payment.

The PBGC is funded not by tax dollars but by sources including insurance premiums paid by sponsors of defined-benefit pension plans, investment income on that money, and money recovered from the companies formerly responsible for the plans.

When the PBGC takes over a pension plan, the plan's liabilities (what is promised to retirees) are matched against the plan's assets (money in trust to pay the promised benefits). To the extent the assets are insufficient, the PBGC will pay benefits based on priority category (benefits that have been recently increased are a lower priority than benefits that have been in place for more than 5 years, for example).

The PBGC also has limits on the amount of benefits it will pay to a retiree. This limit is $54,000 annually in 2010, but it is decreased for early payment (before age 65) and optional forms of payment (like an annuity that will continue to pay out after the retiree's death if their spouse is still alive).

Not all pension plans are eligible for PBGC funding. Some examples of plans that may not be covered by the PBGC are church pension plans and pension plans for small employers.

Companies are more and more leaving retirement planning up to employees by providing such options as 401(k) plans, where the employee contributes the amount he wants and decides how to invest it. Some companies will match a percentage of employee contributions. These are defined-contribution plans, as opposed to pensions' defined-benefit moniker.


Related Fool Articles

Related Terms

Recent Mentions on Fool.com

Advertisement