For many of us, retirement is a concept that does not get a lot of thought, especially if it is decades away. Though it may be a far off notion, it is extremely important to be financially prepared in order to live a comfortable life (whatever that means to you) after you retire. There are many ways that you can curate your retirement portfolio; and one useful tool is that of a pension.
Simply put, a pension is a retirement fund (usually an employee benefit) that requires an employer or employee or both to make regular contributions to an investment fund for the employee’s benefit after retirement. The plan provides an income stream during retirement.
Types of Pensions Plans
Generally, there are two broad categories of pension plans, namely:
- Personal Pension Plan – This is a private pension plan that allows individuals the opportunity to save and invest for retirement without the need of an employer’s contributions (to be discussed in another article).
- Occupational/Employment Pension Plan – This is a pension plan that is offered as an employment benefit. This type can be further broken down into defined benefit plans and defined contribution plans.
Defined Benefit Plan
As the name implies with this plan, the benefit is defined, which means that regardless of how much is contributed by an employee, the benefit amount must be the same as what was originally promised. This benefit is subject to a pre-determined formula, and may include factors such as your tenure, salary amount, and seniority within the business. Note that this formula may be subject to change during your employment or retirement.
With a defined benefit plan, the employer endures all the financial risks of the plan. Therefore, if the return on investment is not sufficient to meet the defined benefit amount, the employer has to pay the difference to ensure that the defined benefit is met. Note that you may only be entitled to the benefits of the pension plan if you are vested with the company.
This is an EXTREMELY simplified example. Note that more factors may go into calculating your pension payout.
Defined Contribution Plan
In contrast to the defined benefit plan, with the defined contribution plan, the monetary input is defined. Instead of setting a pre-determined benefit, the contribution amount is guaranteed. Many times, the employer promises to contribute a certain percentage to the plan, most times by way of matching the employee’s contribution. It appears that the standard employee deduction (in The Bahamas) to fund the plan is 5% of the employee’s gross salary. If the employer matches, they would also contribute 5% to the plan, giving you a total of 10% of your gross salary.
In some cases, employees are allowed to increase their contributions; and, in some cases the employer may match the additional amount as well. The employer does not bear the risk with this type of plan, so there is no obligation on the employer to make up for losses in the pension account. Note that the employee is only entitled to the employer’s contribution if the vesting period is met.
Vesting Period
The vesting period refers to the amount of time that you must work for your employer before earning the right to the employer’s contributions. For example, if your employer has a defined contribution plan and offers to match up to 5% with a mandatory vesting period of five years, you must work for the employer for at least five years before you have access to the employer’s contributions. If you resign before the five-year period expires, you are only entitled to your contributions.
For many companies, the standard vesting period in ten years; however, some companies may have a vesting period as low as five years.
Note: In some cases, a graded approach to vesting is used where you become partially vested throughout your tenure, meaning your ownership in the plan gradually increases. For example, if the vesting period is five years, after the first year, you will be considered 20% vested (and so on). This means that after the first year, you will be entitled to 20% of the employer’s contributions.
Comparison Table:
| Defined Benefit Plan | Defined Contribution Plan |
|---|---|
|
- Promised periodic payment at end (benefit defined)
|
- Sum of money accumulated at end (contribution defined) |
|
- Investment risk/decisions – employer’s responsibility
|
- Investment risk/decisions – individual’s responsibility |
|
- Employer must fill any shortfalls in the pension plan |
- Employer may match contribution |
Final Notes
A pension is a useful tool that can help you prepare for retirement; and if you are job hunting, you may want to find out whether a potential employer offers a pension plan as a benefit. If you are self-employed or your employer does not offer a pension plan as a benefit, all hope is not lost. You can curate a retirement plan with various assets and investment plans.
Stay tuned for a later article where I discuss personal pension plans.