Types of Retirement Plans - Term Paper Example

Term Paper – Types of Retirement Plans Introduction Retirement planning is a crucial factor for both organizations and employees for the purposes of ensuring a secure future after an individual’s job prospects have ended once he/she has reached the predetermined age of retirement. Evidently, the primary concerns of companies and workers with regard to retirement planning are different and so are the approaches that are adopted for his matter. However, the chances of maintaining an employee’s financial independence once his/her tenure at work has ended because of the factor of age or voluntary retirement at an earlier age are dependent upon whether organizations are able to fulfill their commitment to workers and whether employees are able demonstrate essential financial literacy so that they are able to maintain an independent, healthy and secure monetary position upon old-age (Lusardi and Mitchell, 2011). While, it has been established that the responsibility of retirement planning is essentially shared amongst companies and employees, the purpose of this paper is to examine the organizational perspective of the process as per which employee benefits and more specifically retirement plans are based by comprehensively analyzing defined benefit plans and defined contribution plans. According to Beam and McFadden (1998), qualified plans are categorized under two expansive classifications under which one of the categories distinguishes between defined benefit plans and defined contribution plans. The presence of this categorization aids the recognition of plans that demonstrate an alignment with the overall aims of the employee and are therefore, highlighted as a suitable selection. As noted by Beam and McFadden (1998) once organizations are able to identify employees’ long-term objectives an appropriate qualified plan can be created after utilizing various types of alternative plans that are available. Moreover, these plans can then be matched with groups of employees that share comparable career goals and aims. 2. Defined Benefit Plans The selection of a defined benefit plan entails that the document of the plan indicates the amount that has been committed to the employee once he/she reaches the age of retirement (Beam and McFadden, 1998). Thus, the plan document does not state any particular amount which is expected to be contributed by the worker on a yearly basis to the plan itself. As noted by Beam and McFadden (1998), in the case of a defined benefit plan, the responsibility of establishing annual contribution belongs to the actuary who must ensure that the plan carries enough finances which can be deemed as adequate to when the committed amount is eventually disbursed to the employee upon reaching the age of retirement. A critical factor in this case inquires regarding the suited course of action that must be adopted if the plan fund turns out be to be insufficient, Beam and McFadden (1998) assert that in a scenario such as this the duty of contributing the supplementary amount to the plan fund is transferred to the employer. Moreover, defined benefit plans do not operate under the presence of individual participant account. This implies that an employee can declare possession of the plan fund under defined benefit in its entirety (Beam and McFadden, 1998). As stated by Margolis (1995), define benefit plans can be divided into three types that are examined as follows. 2.1 Traditional Pensions In the case of traditional pensions, the benefit that is derived by the employee is associated with a specific formula which includes various factors including the applicant’s compensation and tenure (Margolis, 1995). The execution of traditional pensions involves the establishment of a trust as per which the employer assumes the role of plan sponsor and injects finances into the trust on behalf of plan participants who are the company’s employees (Margolis, 1995). As stated previously, the employee is not expected to distribute any amount towards the trust apart from rendering his/her services to the firm and fulfilling organizational duties as specified under the job. With regard to the placement and collection of these funds until they are disbursed to employees on age of retirement, it must be outlined that monetary collections are not conducted in a separate account for this purpose but are directly infused in the trust. The finances which are present in the trust under the model of traditional pension are secured by governmental agencies including ERISA and managed as per the stipulations of the Internal Revenue Code (Margolis, 1995). Margolis (1995) identifies that in exceptional scenarios, whereby, an employer declares bankruptcy or declares that the trust has become underfunded an insurance policy is enacted by the Pension Benefit Guaranty Corporation (PBGC) to resolve the matter. 2.2 Cash Balance Plans A Cash Balance Plan, also known as CBP is another subcategory which falls under defined benefit plans. Margolis (1995) notes that employee a CBP defines employee benefits in a manner that shares much similarity to a define contribution plan. This notion entails that the committed benefit which is to be provided to the employee upon retirement is provided under CBP in accordance with the stated account balance. According to the United States Department of Labor (2014), the calculation of a specified amount under CBP is conducted under the scheme of “pay credit” and “interest credit” where the former relates to the crediting an employee’s account on an annual basis by a specific percentage of the payment that is offered by his/her employer while, the latter is associated with the incorporation of additional amount that is either fixed or variable and is decided upon in relation with a particular index. A cash balance plan can benefit employees by eliminating investment risks on plan assets because this burden is transferred to the employer, therefore, any decline in the value of investments that are related to the plan does not have a direct impact on the amount that has been committed to the employees by the employer (United States Department of Labor, 2014). However, it must also be identified that any possible investment rewards due to an increase in plan investment value provide benefit to the employer for they are not shared with the employee. As is the case with traditional pensions, plan funds are insured under the directives that are enacted by PBGC. 2.3 Pension Equity Plans The third type of defined benefit plan is known as a pension equity plan or PEP. Under this arrangement the benefit that is derived by the employee upon normal age of retirement is based upon final pay, while, the specified percentage is defined in accordance with the employee’s age and the years of service that have been rendered by the worker (Margolis, 1995). The advantages that are associated with this type of benefit plan are related with the provision of lump-sum benefit that is derived by the employer upon the end of service. Margolis (1995) understands that yearly credits under PEP can be outlined under age, tenure or a combination of both of these components. Furthermore, the PEP eventually defines the sum or totality of benefits by taking into account the percents which have been collected by the worker throughout his/her tenure in the organization. Margolis (1995) asserts that this information is presented in a ‘schedule of percents’ which is an important source of data for establishing the amount of lump-sum benefit when a participant reaches retirement. Thus, the accrued percents as per the ‘schedule of percents’ provide a specific percentage that is applied to final earnings that have been outlined in the plan to arrive at the final benefit amount (Margolis, 1995). 3. Defined Contribution Plans Unlike defined benefit plans where plan funds are accumulated in a trust, the collections of which are insured by the Pension Benefit Guaranty Corporation (PBGC), the management of finances and assets under defined contribution plans is conducted in individual accounts that belong to each of the employees of the organization (Beam and McFadden, 1998). As per the plan document for defined contribution plans, the specific amount that is to be put in by the employer in accordance to the plan is identified however, the employer is not entitled or obligated to fulfill any commitment to the employee regarding the provision of specific benefits (Beam and McFadden, 1998). Therefore, when a plan participant eventually reaches the age of retirement and is permitted to receive the amount he/she shall only be entitled to the amount that is present in his/her account. Beam and McFadden (1998) understand that the negative implication of this characteristic of defined contribution plans is that any decreases in the value of plan investments and the risks that are associated with this occurrence have to be borne by the employee. This is a crucial difference between defined contribution plans and defined benefit plans where the employer bears the risks of a decline in plan investment in case of the latter (Margolis, 1995). The several subtypes of defined contribution plans include 1) 401(k) plans 2) profit-sharing plans 3) employee stock ownership plans 4) money purchase and target benefit plans 5) thrift saving plans (Margolis, 1995). 3.1 401(k) Plans The 401(k) plan is an option of acquiring benefits upon retirement as per the provisions of a cash or deferred arrangement. The mention of a cash or deferred arrangement entails that 401(k) provides employees with the option of deferring the collection of a fraction of their salary that can be either be injected into the 401(k) plan itself (United States Department of Labor, 2014). According to Clark et al. (2006) the 401(k) plan like other forms of defined contribution plans grants individuals with the liberty to decide upon their state of financial preparedness and also empowers them in the management of their finances and savings in addition to guiding the direction of their investments. This level of autonomy is appreciated by employees who may wish to play an active role in their retirement planning; however, it is important to note that this plan also enhances the probability of risk. 3.2 Profit-Sharing Plans Under profit-sharing plans, the employer is granted with the right to decide on the amount that is contributed to the benefit of plan of each employee of the company from either from the organization’s profits or other sources by applying a designated formula to calculate contribution (United States Department of Labor, 2014). As stated by Beam and McFadden (1995), the distinguishing characteristics of profit-sharing plans include the placement of limitations on the contribution of employers in addition with being flexible and upon the discretion of the organization. 3.3 Employee Stock Ownership Plans As per employee stock ownership plans (ESOPs), plan investment is essentially conducted under the form of employer stock whereby, the accounts of employees identify the shares of the company’s stock (Beam and McFadden, 1998). The advantages that are provided by ESOPs can be defined under the provision of significant tax incentives that enhance the attractiveness of this option and the possibility of utilizing this framework as a financing option through the means of borrowing (Pratt, 2004). 3.4 Money Purchase Plans According to Beam and McFadden (1998), the application and execution of money purchase plans is believed to be one of least complex forms of defined contribution plans. The reasons which contribute towards this statement are based on the idea that a money purchase plan makes it a requirement for employers to inject a specific amount into the individual accounts that are possessed by plan participants. For instance, the document plan for this option could specify that employers must put in 8 per cent of the employee’s compensation into his/her individual account. Therefore, upon reaching the age of retirement under this plan the employee is entitled to obtain the total amount that is present in his/her individual account (Beam and McFadden, 1998). 3.5 Thrift Savings Plans Margolis (1995) states that the features of a thrift savings plan can be termed as similar to that of the 401(k) plans in terms of the tax incentives that are provided to the employee under these options. Thus, under this option a plan participant is granted the right to make a tax deferment to the individual account which ensures that the total amount is not taxed until the disbursement has been made which is an advantage of selecting this scheme (Margolis, 1995). References Beam, B. T., & McFadden, J. J. (1998). Employee benefits. Chicago, Ill: Dearborn Financial Pub. Clark, R. L., d’Ambrosio, M. B., McDermed, A. A., & Sawant, K. (2006). Retirement plans and saving decisions: the role of information and education.Journal of Pension Economics and Finance, 5(1), 45-67. Lusardi, A., & Mitchell, O. S. (2011). Financial literacy and retirement planning in the United States (No. w17108). National Bureau of Economic Research. Margolis, H. S. (1995). The ElderLaw portfolio series. Boston: Little, Brown. Pratt, D. A. (2004). Focus on... ESOPs. Journal of Pension Benefits, 11(2), 50 United States Department of Labor (2014). Types of Retirement Plans. Retrieved from [7th March, 2014] Read More