The term pension plan refers to an arrangement whereby an employer agrees to provide employees with a stream of income payments after they retire. Pension plans are typically divided into two broad categories: defined benefits plans and defined contribution plans.
Companies will provide employees with a pension plan as part of a larger array of employment benefits. Pension plans are structured by companies to provide a periodic and reliable source of income when the employee reaches the plan’s normal retirement age. Generally, pension plans fall into one of the following two categories:
- Defined Benefits Plans: consists of a predetermined schedule of retirement income, which is typically a function of the employee’s salary and years of service. In a defined benefits plan, the employee’s retirement income benefit is known, and the employer’s contribution to the fund will vary with the investment’s performance.
- Defined Contribution Plans: consists of a predetermined schedule of fixed employer contributions to a pension fund on behalf of the employee. In a defined contribution plan, employer contributions are known, but the retirement income benefit will depend on the investment’s performance.
While defined benefits plans consist of employer contributions, defined contribution plans may consist of both employer and employee contributions. Qualified defined contribution plans will also have a vesting schedule. Employee contributions will vest immediately (100% owned by the employee), while employer contributions typically vest after 3 years.
In addition to employer-sponsored pension plans, Social Security provides retirement income to qualified citizens of the United States. Generally, citizens are eligible for retirement benefits if they’ve worked for ten or more years in a job that pays into the Social Security system.