What are pension funds?
According to the Bureau of Labor Statistics, about 94% of union workers and 67% of nonunion workers had the chance to participate in pension funds through their employers in 2019.
A pension fund consists of regular contributions from employers and/or employees that are set aside for retirement. The funds may include:
These assets are invested and allowed to compound tax-free while an employee is working. Once they retire, employees receive pension income from these contributions.
The pension benefit is usually based on a formula involving age, wages earned and years of employment, and in the case of defined-contribution plans, the performance of the investments. Benefits are usually paid monthly although some funds may allow a lump sum payment.
How do you set up a pension plan?
Once you decide to establish a pension plan for your employees, you should consult with a professional to learn about the types of plans available and the tax advantages for your business.
Some of the administrative steps include:
- Creating a written document outlining the terms of the plan
- Arranging investment of funds
- Establishing record-keeping systems
Once the plan is created, you can let your employees know how it works so they can decide whether they want to participate. There are usually eligibility requirements that must be met before joining the pension fund or becoming eligible for payments; for example, the length of time an employee works for a company.
When the plan is in operation, you must:
- Arrange for the appropriate employer and employee contributions to be made
- Manage the assets
- Follow the Employee Retirement Income Security Act (ERISA)
- Distribute the benefits when employees are eligible
Because of the complexities of sponsoring a retirement plan, some businesses rely on the services of professionals.
What are pension funds required to do by law?
Pension plans offered by private companies are regulated under the Employee Retirement Income Security Act (ERISA). This law was put in place in 1974 to ensure employees are protected and that their pensions are available when they retire.
Employers who offer a pension plan must follow ERISA guidelines about:
- How plans are funded and structured
- Employee eligibility to participate and accumulate benefits
- Minimum employment requirements before employees have an unconditional claim in the plan
- Eligibility if an employee leaves a job and returns
- Spousal rights to benefits in the event of the employee’s death
- Responsibilities and liabilities of fiduciaries who manage the assets
- The type of information provided to plan participants and when it must be given
- The grievance and appeals process for participants receiving benefits
ERISA also allows participants to sue for benefits if they feel the plan’s terms have been breached. Payment of benefits is guaranteed through the Pension Benefit Guaranty Corporation if a plan is terminated .
Common types of pension plans
If you decide to establish a pension fund for your employees, you have the flexibility to choose the type of fund you offer. Here are some of the most common:
Defined-benefit plans
Defined-benefit plans are funded by employers. They guarantee a specific payment when an employee retires. The payment may be a specific dollar amount or calculated using a formula based on salary, age and years of service.
Employees are paid from a shared trust fund upon retirement and not an individual account. If the pension plan’s investments aren’t able to cover the amount of these benefits, the company is liable for the pension benefit.
Because of this risk to employers, many companies are moving away from defined-benefit plans. These plans dropped by about 73% over three decades, from 1986 to 2016.
Defined-contribution plans
A defined-contribution plan is funded by contributions from employees. Each participant has an individual account, chooses how much to contribute through payroll deductions and how to invest funds. Employers may provide a matching contribution.
Benefits are paid based on the amounts contributed to the account and the performance of the plan’s investments. These plans are growing in popularity because there’s less liability for the employer and more flexibility for employees in managing their retirement funds. A 401(k) plan is the most common type of defined-contribution plans.
Profit-sharing or employee stock ownership plans
Some employers share profits and contribute to pension plans in the form of cash or employer stock. These plans typically use a formula to determine the employer contribution.
Access to employer-sponsored pension funds
Overall, about 85% of union employees and 51% of nonunion employees participate in a pension fund through their employer.
Defined-contribution plans are the most common option given to private-sector employees, according to data from the Bureau of Labor Statistics. In 2018:
- 51% of private-sector workers had the option to join a defined-contribution plan
- 4% of private-sector workers had the option to join a defined-benefit plan
- 13% of private-sector workers had access to both types of plans
Should you offer a pension fund to your employees?
The federal government encourages you to assist employees in saving for retirement by providing you with incentives and tax credits when you sponsor a pension plan. However, it can be complicated to establish one.
Advantages of offering an employee pension plan
- You and your employees have a vehicle to save for retirement
- Employer contributions are tax-deductible
- Employee contributions aren’t taxed until the benefit is paid
- Assets in the plan grow tax-free
- Employee recruitment and retention is easier when your compensation package is more attractive
- Tax credits are available for the costs of setting up and administering a retirement plan
Disadvantages of offering an employee pension plan
- Can be time-consuming and expensive to administer
- Typically requires professional support to create and manage
Frequently asked questions about pension funds
Is a 401(k) a pension fund?
401(k) plans are a type of defined-contribution pension plan. Employees make contributions that may or may not be matched by employers. These plans help employees save for retirement, but with less risk to employers. There’s no guarantee of the amount you receive upon retirement.
What is the difference between a provident fund and a pension fund?
Provident funds are national pension funds available in countries such as India, Mexico, Singapore, Hong Kong and Malaysia. Similar to pension funds, both employers and employees contribute and benefits are paid to employees once they retire. Unlike pension funds, which are offered and managed by private employers, provident funds are managed by government and are mandatory.
How are pension funds invested?
While there are federal laws governing the responsibilities of a pension plan’s fiduciaries, ERISA doesn’t specify the specific investments private pension funds should make. It’s up to the plan’s managers to assess market fluctuations and investment risks, and maximize returns for plan members.
Traditionally, this means investing in blue-chip stocks, fixed-income securities and investment-grade bonds. However, some fund managers may also invest in equity, real estate and infrastructure to help generate higher portfolio returns.
