Pension plan is a fund financed by the contributions of the employer for the eventual payments of retirement benefits. Employers can also share with employees the amount invested in the fund. Pension plans are managed by different categories of pension plan sponsors. These can be either public or private entities operating on behalf of their employees. A private pension plan sponsor is generally referred to as corporate or private plan. Alternatively, a public sponsor can be either a state or a local government. In case the sponsor is a union offering pension plans to its members, the sponsor is called Taft Hartley plans. Despite their low level of liquidity, pension funds represent the major investors in the international financial system. There are several reasons for the development of pension plans. The most important is the favourable tax treatment associated to the investment in pension contracts. Indeed, contributions are tax exempted during the whole working life of the employees, or in general until the funds are withdrawn. From employers' perspective, there is also a strong incentive to pay contributions that are tax deductible. However, in order to benefit from tax exemption, the fund must be a qualified pension plan, which means that it has to meet some federal requirements. There are two types of pension plans: defined-benefit plans and defined-contributions plans. There is also another type of pension plans called cash balance plan that is a combination of the two basic types.
In defined-benefit plans, the retirement benefits are paid regularly (in general monthly) by the plan sponsor to employees for life beginning at retirement. In case of death before retirement, the same payments are paid to the employees’ beneficiaries. According to this method, the pension plan sponsor is fully responsible for the employees’ benefits that are determined in advance. The formula for the calculation of retirement benefits takes into account the employees' earnings and years of service. The benefits are then paid when the employees meet some requirements, such as a certain number of years of service, while the continuation with the employer or the union is not relevant. Typically, pension plan sponsors can protect themselves against the risk of being unable to provide the amount agreed by the pension contract by purchasing an annuity policy from a life insurance company. Defined - benefit plans guaranteed by insurance are called insured benefit plans. In recent years, we have assisted to the decline of defined-benefit plans. Many pension plans have been frozen by the most important firms in the USA, like IBM, while others like Microsoft have not adopted defined-benefit plans at all. The competition with firms offering defined-contribution plans imposed too high costs on defined-benefit plan sponsors and they became unsustainable. Most generally, all pension plan sponsors, either private or public, are still facing a crisis today. In essence, this crisis consisted of an accumulation of large deficits by pension funds that threatened the solvency of corporations and governments. The crisis was caused principally by the lack of appropriate regulation and the misleading accounting rules that resulted in the underestimation by firms of pension fund liabilities.
In defined-contribution plans, the sponsor makes contributions on behalf of the employee in the fund and does not pay any retirement benefit. In general, contributions made by pension plan sponsors reflect a portion of the employee's salary. The retirement benefits are not known in advance and they depend on the contributions made to the fund and on the performance of the investment option selected by the employee. In this case, pension plan funds have no debt obligations for the retirement period and so they do not face any investment risk as it occurs in case of defined-benefit plans. In general, the most selected investment option is represented by mutual funds. In any case, according to the U.S. Department of Labour regulation, firms must ensure a different range of investment possibilities between families of mutual funds that serve specific investment objectives. The broader sector of defined-contribution plans is the 401(k) plan in the private sector, the 403(b) plan in the non-profit sector and the 403(b) plan in the public sector. These plans equally offer the lowest costs as compared to other legal forms of defined-contribution plans such as money purchase pension plans or employee stock ownership plans (ESOPs), and several investment options. Similar to the 401(k) in the private sector, the largest public defined-contribution plan sponsor, the Federal Retirement Thrift, offers a range of investment opportunitiesto federal employees. Finally, to overcome the shortage related to both basic types of pension plans described above, hybrid pension plans have been created, resembling some of their basic features. There are several categories of hybrid pension plans (floor-offset, pension equity, etc.), but the most common is the so-called cash balance plan. In essence, in a cash balance plan, benefits are fixed in advance, following a formula that takes into account different factors as in defined-benefit pension plans. However, as in contribution plans, the employee has an account that is credited with an amount, resembling an employer’s contribution, monitored in a regular statement. Moreover, in many cash balance plans, vested benefits can be taken as a lump sum and rolled into an Investment Retirement Plan (IRA) when the employee terminates employment.

FABOZZI F., MODIGLIANI F. and JONES F. (2010), Foundation of Financial Markets and Institutions, Pearson International Edition.

Editor: Bianca GIANNINI

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