Understanding retirement plans can be difficult, especially when one such as a pension plan or a defined benefit plan is at the hands of your employer. Now, this is not a bad thing that your employer is the one managing your retirement investment funds, it is just important to understand what your pension is worth.
The first thing that any employee should understand about their pension is that it is commonly referred to as a defined benefit plan. The retirement plan is calculated by an employer once the job is accepted and will be adjusted along the way to guarantee your retirement savings once eligible.
But before we get into how to calculate your pension worth, let’s really dive into what a defined benefit plan is and all the aspects that make up one.
It’s important to factor in that for most of this article we will be referring to a traditional pension plan.
Defined Benefit Plan
Defined benefit plans are pensions that are more popular in the public sector than they are in the private. Now they are not non-existent in the private sector so it is still worth knowing about if that happens to apply to you.
At the end of 2019, according to the OECD, global pensions exceeded the $50 trillion mark. Even if they are not as popular as the 401(k) in the U.S. sometimes an employer may offer the option between the two, or a combination between a defined benefit plan and a defined contribution plan.
The pension plan is traditionally referred to as a defined benefit plan but as private sectors move towards the less liable option of a 401(k) sometimes you may hear someone refer to a pension as a defined contribution plan.
So let’s get into the specifics.
What Is a Pension?
A defined benefit plan (pension) is completely different from a defined contribution plan because instead of you as the employee managing the fund, the funds’ management is left completely up to the employer.
Often because of the sometimes complicated risks of offering a retirement plan like this, a company may hire outside management to help with the allocation of funds. This is because a pension is a guaranteed amount of money to the employer regardless of the market. If the employer fails to get this amount from investments they are required to pay the employer from out-of-pocket cash the difference.
Pension plans have the catch that you have to meet a certain number of years worked within a company to access your pension plan. Usually, the MRA or the minimum required age to access a pension retirement plan is 10 years working with a company.
The guaranteed amount of money comes from the calculated benefit which takes into consideration the number of years worked, the history salary, and more to come up with a number that will be required to pay out in either one of two ways. It’s good to note that now some pensions actually allow employees to make their own contributions alongside the employers.
Once an employee meets the MRA and decides that they want to access their funds for retirement, they can choose one of the following categories.
The two options are collecting payments in an annuity or collecting a lump sum.
An annuity allows the employer to get paid on a monthly basis until death from the start of retirement. Some people like this because it allows the retirement fund to be portioned and blanched if you struggle to manage money or see the full plan with money. There are two types of annuity plans.
Single-Annuity: This is for those who are not married or have a spouse to share the benefits with. The benefit will stop being distributed at death. Keep in mind that with this option there will be no beneficiary to receive your retirement savings.
Joint-Annuity: This is for a spouse that survives the main benefactor. In this case, the monthly payments would go to that spouse until death. This is really common for married couples as retirement planning is usually done together.
Period-Certain-And-Life Annuity: That’s a mouthful but one worth thinking about. This can pay your beneficiary for a desired amount of time if they were to survive you. This could be for 5, 10, 15, or even 20 years, after your passing.
This option is meant for those who may want to pass it on to their children. It also will enlarge the size of the checks because of the shortened length of time.
As it sounds you can also receive your earned benefits in one big lump-sum of money. Some employees prefer to manage their own money and get it all at once and spend as they see fit. This can also be an option for joint-annuity as the spouse can change their payment after an incidence of death.
The Occasional Defined Contribution Pension Plan
Pensions are traditionally referred to as the Defined Benefit plan but there are instances in which someone will refer to their pension under the DC plan. In this case, the employer will still make a specific plan for an employee and will match a certain percentage or dollar amount that the employee contributes to their own plan.
It’s important to know that there are set limits by the IRS for how much an employee and an employer can contribute to a retirement plan. It also is different than the traditional pension plan because they can access it at 59 ½ in almost every single plan. This is as opposed to being eligible for your funds after the 10 years MRA or minimum requirement age.
Private sectors are moving away from the traditional pension plans and more to these plans which are more commonly referred to as 401(k) or 403(b) funds.
Understanding Your Worth
So what is the breakdown of the traditional pension plan or the defined benefit plan and how it really calculated? Well, in simpler terms the more you work the better chance for success you have.
Years added not only will make your multiplier larger for your per month payment but it also gives you a chance to improve your salary. This is also a major factor in determining your guaranteed benefit.
It’s important to know that each definite benefit plan will have its own competitive formula to calculate the guaranteed money. But we can get into an example here.
Usually, a company will need to go over a salary number to start the calculated benefits. This number is typically the average of the two to five consecutive years in which an employee has their highest salaries.
Then this average salary number will be multiplied by what is called the pension factor. This is typically between 1.5 and 3 percent.
This needs to be calculated by the years worked. But this isn’t as simple as someone saying you’ve been here for 12 years so now you will be compensated for 12 years. Instead, the amount of years worked is actually determined by the number of hours you worked and logged with that company.
This last factor is majorly important and is not considered when trying to find the value of your pension. This can be a great benefit if you are working a lot of hours in a year but also can end up being not great if you don’t work as many hours.
For instance, a part-time employee will be credited with a fraction year. Other stipulations apply like overtime hours not counting. However sick leave and vacation time may count. These are some of the variables that may be different among pension plans.
Understandably that can be still difficult to follow along with. Consider this example of a pension calculation to follow. Remember, every plan is different and this is a rough estimate to give you an idea of what your pension worth is.
Let’s say Joe has worked for his company for 35 years and has decided to retire. Joe’s specific defined benefit plan specifies that they use the average of the best four consecutive years of salaries. His best years were $50,000, $55,000, $60,000, and $65,000.
The average of these salaries was $57,500. Now the benefit factor that the company is using is 1.5 percent. So now $57,500 multiplied by 1.5 percent also multiplied by the years worked comes out to $30,187.50. This is your annual pension. Now the employee can choose to get the money in monthly installments or they can choose the lump-sum option.
The annuity option or monthly payment will be $2,515 and some change. This must be paid out till death.
As mentioned above if an employee were to consider working additional years it may change this number by offering a different number of consecutive years and offer up an additional year that must be paid out.
If Joe wanted to take the lump-sum payment it is best to be advised by a financial planner who can assist with the allocation of funds on your own instead of monthly installments.
Don’t Forget ERISA
Don’t forget that the Employee Retirement Income Security Act of 1974 is a federal law that is meant to protect you. This law sets forth minimum standards in the private sector industry that are solely meant to protect the individual.
This act requires fiduciaries to be transparent and offer consistent information on your money with their investments. The Act also makes plans to provide an appeals process in case there is a dispute that needs to take place.
This would allow you to sue a company if they were to breach their agreement or the basic pension standards. The best example would be if they mismanaged your money, you wanted to retire, and they refused to pay the difference in the cash payout mentioned. This is where the ERISA Act comes in.
Vesting falls right under this and is important for employees to understand. Vesting is a legal term that means that an employee has earned the right to a future payment, benefit, etc.
Pensions And Their Worth
Understanding a pension is incredibly important to make sure that your employer is holding up the end of their bargain. It’s also important for you to understand because even though you may be able to access your pension plan after just 10 years of working, knowing the added value to years beyond that is extremely important.
Private sectors as mentioned have been moving away from the pension plans or the defined benefit plans because of the liability factor. They are solely responsible for your retirement savings and if they don’t meet their end of the bargain they are legally required to pay the differences in cash-payouts. This is an important piece of information to retain.
If you are working in the public sector you may have the option to choose between a pension plan and a defined contribution plan, or even in some cases, an employer will allow you to split some of your funds and do both. It is important to consider your career and how long you plan to stay in your career when deciding to choose between something like a 401(k) and a pension plan.
It’s also important to remember that with pension plans there are different ways of getting paid once you access your retirement savings. You can get it all at once or you can get paid monthly checks. It may make sense to consult a financial advisor on this because offering benefits to your spouse if they survive may be an important thing for your family.
Having the information in itself is powerful and knowing the worth of your pension now and in the future will serve you well in retirement.