A pension plan is a contract between employer and employee. However, an employer can modify or alter the plan unilaterally in most cases. In the United States, most employer-provided pension plans are “defined benefit plans”; the other major type is referred to as a “defined contribution plan.”
- DEFINED BENEFIT PLANS: Under such plans, employees receive benefits based on a formula, usually years of service and percent of salary. This arrangement promises the employee a benefit in the form of a specific dollar amount per payment period dur-ing retirement. For example, the plan might specify that a worker will receive an annual pension equal to 1.5 percent of his or her average salary over the most recent five years, times the years of service. Upon retirement, the employer or plan administrator pays that specific amount.
- DEFINED CONTRIBUTION PLANS: Under these plans, employers pay a specific amount or percentage into a pension fund annually. The funds are allocated to individual employee accounts. Retiring employees receive benefits according to how much money they have in their fund upon retirement. This may be taken as a lump sum or used to purchase an annuity that will pay monthly benefits for a set number of years. The amount of annuity benefit and the years payable depends on how much was in the fund at retirement.
- EMPLOYEE STOCK OPTION PLANS (ESOPs): ESOPs are considered defined contribution plans. In such plans, employees either earn (as an employee benefit) or purchase company stock. At least 51 percent of the assets of an ESOP must be invested in the company. (Conversely, regular defined benefit or defined contribution pension programs may not invest more than ten percent of funds into company stock, excepting some 401(k) plans.) ESOPs enhance employee motivation and productivity but also create risk because a large portion of an employee’s retirement wealth is all in one investment.
- SIMPLIFIED EMPLOYEE PENSION PLANS (SEPs): Under these plans, employers merely contribute to employees’ private individual retirement accounts (IRAs).