Legal Definitions - pension plan

A pension plan is a type of retirement savings program established by an employer or an employee organization to provide income to employees after they stop working. These plans are designed to help individuals save for their retirement years, either by providing a steady stream of income or by allowing them to defer a portion of their current earnings until retirement.

In the United States, most pension plans are regulated by a federal law called the Employee Retirement Income Security Act (ERISA). ERISA sets standards for how these plans must be managed, ensuring that employees' retirement savings are protected and that they receive the benefits they are promised.

Pension plans generally fall into two main categories:

• Defined-Benefit Pension Plan: In this type of plan, the employer promises a specific, predetermined monthly payment to the employee upon retirement. This payment is often calculated based on factors like the employee's years of service and their final salary. The employer bears the investment risk, meaning they are responsible for ensuring there's enough money to pay out the promised benefits, regardless of how investments perform.

• Defined-Contribution Pension Plan: With this plan, the employer (and often the employee) contributes a set amount of money regularly into an individual account for the employee. The final amount the employee receives at retirement depends on how much was contributed and how well the investments in their account performed over time. The employee typically bears the investment risk. Common examples include 401(k) plans.

Other distinctions include:

• Contributory vs. Noncontributory: A contributory plan involves contributions from both the employer and the employee. A noncontributory plan is funded solely by the employer.

• Qualified vs. Nonqualified: A qualified pension plan complies with specific federal tax laws (like ERISA) and offers tax benefits, such as tax-deferred growth on investments. A nonqualified plan does not meet these specific requirements and typically serves to provide additional benefits to a select group of employees, often executives, without the same tax advantages or broad ERISA protections.

• Top-Hat Plan: This is a specific type of nonqualified plan maintained primarily for a select group of management or highly compensated employees. These plans are generally exempt from many of ERISA's broad protective provisions because the law assumes these executives have enough influence to negotiate their own terms.

Examples:

• Example 1 (Defined-Benefit, Noncontributory, Qualified): Sarah worked for a municipal government for 25 years. Upon her retirement, the city's pension plan, which was entirely funded by the city and regulated by state and federal laws, began paying her a fixed monthly amount for the rest of her life. This amount was calculated as a percentage of her average salary during her highest-earning years, multiplied by her years of service. Sarah never contributed any of her own money to this plan, and the city was responsible for managing the investments to ensure her payments could be made.

  This illustrates a traditional defined-benefit pension plan because Sarah is guaranteed a specific payout amount, and it's noncontributory as only the employer funded it. It's also a qualified plan, adhering to regulations to provide tax-advantaged retirement income.

• Example 2 (Defined-Contribution, Contributory, Qualified): Mark works for a technology company that offers a 401(k) plan. Each month, Mark chooses to have 5% of his salary deducted and invested in various funds within the plan, and his employer matches 3% of his contribution. The value of his retirement account fluctuates based on the performance of these investments. When Mark eventually retires, he will withdraw the accumulated funds from this account, which will serve as his retirement income.

  This demonstrates a defined-contribution pension plan because the contributions are set, but the final retirement benefit depends on investment performance. It is contributory as both Mark and his employer put money in, and it's a qualified plan, offering tax benefits for his retirement savings.

• Example 3 (Top-Hat, Nonqualified): The CEO of a major pharmaceutical company has a standard 401(k) plan like other employees. However, due to her executive position, she also participates in a separate, unfunded "Executive Retirement Plan" where the company promises to pay her a significant lump sum upon her departure, in addition to her other retirement benefits. This special plan is not subject to the same strict funding and disclosure rules as the company's general employee pension plans.

  This is an example of a top-hat pension plan because it's designed specifically for a highly compensated executive, providing deferred compensation beyond standard benefits, and is subject to fewer ERISA regulations due to the executive's influence and position. It is also a nonqualified plan, as it doesn't meet the broad ERISA requirements for general employee plans.