Legal Definitions - Pension

A pension is a type of retirement plan where an employer provides regular payments to an employee after they retire, typically based on their years of service and earnings. It represents a form of deferred compensation, meaning money earned during working years is paid out later in life to support the individual in their post-employment years.

There are two primary types of pension plans:

• Defined Benefit Plan: In this type, the employer promises a specific, predetermined monthly payment to the employee upon retirement. This payment is usually calculated using a formula that considers factors like the employee's salary history and how long they worked for the company. The employer is responsible for investing the funds and ensuring there is enough money to pay the promised benefits, meaning the employer bears the investment risk.
• Defined Contribution Plan: Here, the employer (and often the employee) makes regular contributions into an individual investment account set up for the employee. The amount the employee receives in retirement depends entirely on how much was contributed and how well the investments in that account performed. The employee bears the investment risk, as there is no guaranteed payout amount. Common examples include 401(k)s and 403(b)s.

Pension plans are heavily regulated by federal law, primarily the Employee Retirement Income Security Act (ERISA). ERISA sets standards for how these plans must be managed, ensuring transparency, protecting employee rights, and establishing fiduciary duties for those managing the funds. For defined benefit plans, the Pension Benefit Guaranty Corporation (PBGC) acts as an insurance agency, protecting a portion of employees' benefits if a company's pension plan fails.

Examples:

• Example 1 (Defined Benefit Plan): After working for 35 years as a teacher in the public school system, Maria retires. She receives a monthly check from the state's teacher retirement fund for the rest of her life. The amount of this check was determined by a formula that factored in her highest average salary during her last few years of teaching and her 35 years of service. The state government is responsible for managing the pension fund to ensure it can meet its obligations to all retired teachers, regardless of market fluctuations.

  Explanation: This illustrates a defined benefit plan because Maria is guaranteed a specific, predictable payment amount each month, determined by a formula based on her salary and length of service. The state, as the employer, bears the financial responsibility and investment risk for funding these payments.

• Example 2 (Defined Contribution Plan): David works for a large software company. Each pay period, his employer contributes 5% of his salary into a 401(k) account that David manages, choosing from various investment options. David also contributes an additional 7% of his own salary. When David retires, the amount he has available will be the total of all contributions made by him and his employer, plus any investment gains (or minus losses) over the years. There is no guaranteed monthly payout amount; it depends entirely on his account balance at retirement.

  Explanation: This demonstrates a defined contribution plan. The employer's obligation is to make regular contributions to David's individual account. The final retirement benefit is not a guaranteed sum but rather the accumulated value of the contributions and their investment performance, with David bearing the investment risk.

• Example 3 (ERISA's Role in Plan Protection): "Old-Line Manufacturing Co." had provided a defined benefit pension plan to its employees for decades. However, due to unforeseen economic challenges, the company declared bankruptcy and could no longer afford to pay its retirees their promised pensions. Because Old-Line Manufacturing Co.'s plan was covered by ERISA and had paid premiums to the PBGC, the PBGC stepped in. It took over the administration of the pension plan, ensuring that the retirees continued to receive a significant portion of their promised benefits, up to the limits set by law, even though their former employer had failed.

  Explanation: This example highlights the protective role of ERISA and the PBGC. ERISA mandated the existence of the PBGC, which acts as an insurer for defined benefit plans. When Old-Line Manufacturing Co.'s plan failed, the PBGC's intervention, as required by ERISA, protected the retirees' benefits, illustrating the federal oversight designed to safeguard retirement savings.