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The first step to
understanding your retirement benefits is to find out what kind
of retirement plan your employer has. There are two major types
of plans, defined benefit and defined contribution, which are
described here and outlined in Table 1. Keep in mind that your
employer may have more than one type of plan, and may have
different participation requirements for each.
A
defined benefit plan, funded by the employer, promises you a
specific monthly benefit at retirement. The plan may state this
promised benefit as an exact dollar amount, such as $100 per
month at retirement. Or, more often, it may calculate your
benefit through a formula that includes factors such as your
salary, your age, and the number of years you worked at the
company. For example, your pension benefit might be equal to 1
percent of your average salary for the last 5 years of
employment times your total years of service.
A
defined contribution plan, on the other hand, does not
promise you a specific benefit amount at retirement. Instead,
you and/or your employer contribute money to your individual
account in the plan. In many cases, you are responsible for
choosing how these contributions are invested, and deciding how
much to contribute from your paycheck through pretax deductions.
Your employer may add to your account, in some cases by matching
a certain percentage of your contributions. The value of your
account depends on how much is contributed and how well the
investments perform. At retirement, you receive the balance in
your account, reflecting the contributions, investment gains or
losses, and any fees charged against your account. The
401(k) plan is a popular type of defined contribution plan,
and there are three types of 401(k) plans: traditional,
SIMPLE 401(k), and
Safe Harbor 401(k) plans. The
SIMPLE-IRA plan,
SEP,
employee stock ownership plan (ESOP), and
profit-sharing plan are other examples of defined
contribution plans. (See explanations of the various types of
plans in the Glossary at the end).
Note
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Employers can choose whether to offer a retirement plan to
employees; Federal law does not require employers to offer
or to continue to offer a plan.
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The Pension Benefit
Guaranty Corporation (PBGC) guarantees payment of certain
retirement benefits for participants in most private defined
benefit plans if the plan is terminated without enough money
to pay all of the promised benefits. The government does not
guarantee benefit payments for defined contribution plans.
For more information, see the
PBGC’s Web site.
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Some hybrid plans – such
as
cash balance plans – contain features of both types of
plans described above. See the Glossary for information on
this type of plan.
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Table 1. Characteristics Of Defined Benefit And Defined
Contribution Plans |
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Defined Benefit Plan |
Defined Contribution Plan |
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Employer Contributions
and/or Matching Contributions |
Employer funded.
Federal rules set amounts that employers must contribute
to plans in an effort to ensure that plans have enough
money to pay benefits when due. There are penalties for
failing to meet these requirements. |
There is no
requirement that the employer contribute, except in the
SIMPLE 401(k) and Safe Harbor 401(k)s, money purchase
plans, SIMPLE IRA and SEP plans.
The employer may choose to match a portion of the
employee’s contributions or to contribute without
employee contributions. In some plans, employer
contributions may be in the form of employer stock.
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Employee Contributions |
Generally, employees
do not contribute to these plans. |
Many plans require the
employee to contribute in order for an account to be
established. |
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Managing the
Investment |
Plan officials manage
the investment and the employer is responsible for
ensuring that the amount it has put in the plan plus
investment earnings will be enough to pay the promised
benefit. |
The employee often is
responsible for managing the investment of his or her
account, choosing from investment options offered by the
plan. In some plans, plan officials are responsible for
investing all the plan’s assets. |
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Amount of Benefits
Paid Upon Retirement |
A promised benefit is
based on a formula in the plan, often using a
combination of the employee’s age, years worked for the
employer, and/or salary. |
The benefit depends on
contributions made by the employee and/or the employer,
performance of the account’s investments, and fees
charged to the account. |
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Type of Retirement
Benefit Payments |
Traditionally, these
plans pay the retiree monthly annuity payments that
continue for life. Plans may offer other payment
options. |
The retiree may
transfer the account balance into an individual
retirement account (IRA) from which the retiree
withdraws money, or may receive it as a lump sum
payment. Some plans also offer monthly payments through
an annuity. |
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Guarantee of Benefits |
The Federal
government, through the Pension Benefit Guaranty
Corporation (PBGC), guarantees some amount of benefits. |
No Federal guarantee
of benefits. |
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Leaving the Company
Before Retirement Age |
If an employee leaves
after vesting in a benefit but before the plan’s
retirement age, the benefit generally stays with the
plan until the employee files a claim for it at
retirement. Some defined benefit plans offer early
retirement options. |
The employee may
transfer the account balance to an individual retirement
account (IRA) or, in some cases, another employer plan,
where it can continue to grow based on investment
earnings. The employee also may take the balance out of
the plan, but will owe taxes and possibly penalties,
thus reducing retirement income. Plans may cash out
small accounts. |
Action Item
Ask your plan
administrator, human resources office or employer for
information on what type of plan or plans you have at work. You
can ask for a copy of the
Summary Plan Description (the retirement plan booklet that
you should receive when you enroll in the plan) and review the
information about the plan.
Source:
U.S. Department of Labor
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