Pension

A benefit, usually money, paid regularly to retired employees or their survivors by private businesses and federal, state, and local governments. Employers are not required to establish pension benefits but do so to attract qualified employees.

The first pension plan in the United States was created by the American Express Company in 1875. A few LABOR UNIONS and state and local governments began to offer pension plans shortly thereafter, and by 1935 governments in half the states and many businesses were offering pension plans. In 1997 about half of all U.S. workers had pension plans.

Employers establish pension plans by paying a certain amount of money into a pension fund. The money paid into this fund is not taxed to the employer, and it is not taxed to the employee until the employee retires and begins to collect pension benefits. The employer gives control of the pension fund to a trustee, who may invest the money in stocks and bonds and other financial endeavors to increase the fund. Some pension plans require the employee to make a small, periodic contribution to the fund.

The amount of pension that a pensioner receives depends on the type of pension plan. Pension plans generally can be divided into two categories: defined benefit plans and defined contribution plans. A defined benefit plan provides a set amount of benefits to a pensioner. Under a defined contribution plan, the employer places a certain amount of money in the employee's name into the pension fund and makes no promises concerning the level of pension benefits that the employee will receive upon retirement. Employers using defined contribution plans contribute an amount into the pension fund based on the employee's salary. As a result, higher-paid employees receive larger pensions than do lower-paid employees.

The same is true for defined benefit plans: employers tend to offer larger pensions to higher-paid employees. The difference between the two types of plans is that in a defined contribution plan, the employee assumes the risk of investment failure because the funds are not insured by the federal government. Under most defined benefit plans, the employer assumes the risk that pension funds will not be available. Employees assume little risk because most funds are insured by the federal government to a certain limit.

The most important issue to pensioners is the potential loss of their pension benefits. This issue is of less concern when the government is the employer because governments have access to additional funds. Such is not the case with private businesses. Before the 1970s employees did not always receive their promised pension benefits. An employee could lose his or her pension if the employer went out of business and employers could fire long-time employees just before their pensions vested to avoid paying pensions. Citing the profound effect that pension plans have on interstate commerce and the economic security of the country, Congress enacted the EMPLOYEE RETIREMENT INCOME SECURITY ACT of 1974 (ERISA) (29 U.S.C.A. § 1001 et seq.) to regulate pension plans created by private businesses other than religious organizations.

ERISA is a complex collection of federal statutes that take precedence over most state pension laws. The act encourages the creation of pension funds by making employer contributions to pension funds tax free. ERISA also is designed to ensure that pension funds promised to an employee will be available. It establishes rules for the vesting of pensions based on the employee's age and length of employment. Under the law an employer using a pension plan that is not funded by the employees may choose one of several methods for vesting of pensions. An employer may allow all pension benefits to become nonforfeitable once the employee has completed five years of employment. In the alternative, an employee may be guaranteed a percentage of pension funds according to length of service, with the percentage increasing as the length of service increases. An employee with three years of service is guaranteed 20 percent of the derived benefit from the employer contributions to the pension plan. After four years the employee has a right to 40 percent of the benefits; after five years the percentage is 60; after six years the percentage is 80; and an employee who completes seven years of service becomes fully vested. An employee is always entitled to the amount of money she or he has contributed to a pension fund.

Under ERISA, the fiduciaries who control the pension funds must meet certain reporting requirements. The act restricts the kinds of investments that trustees can make using pension funds. It mandates that employers make annual contributions to pension funds, and it devises formulas for setting minimum contribution levels. These formulas are created in actuarial tables based on such factors as the turnover of the participants in the plan, the life expectancy of the participants, the amount of money in pensions promised to employees, and the success of the pension fund's investments. The act authorizes criminal penalties for violators of pension laws and provides CIVIL LAW remedies to victims of pension misuse or abuse.

An employer who is delinquent in making contributions to the pension fund may have to pay penalties. ERISA requires employers to report to pension holders significant facts regarding the pension fund, such as a summary describing in clear language how the plan works, what benefits it provides, and how such benefits can be received. The employer also must report annually to each employee the amount of benefits that have accrued and have vested, and the earliest date on which the employee's pension will vest as of the date of the report.

ERISA created the Pension Benefit Guaranty Corporation (PBGC) to ensure the payment of certain benefits of pension plans. PBGC is a government corporation within the U.S. DEPARTMENT OF LABOR that is governed by the secretaries of labor, commerce, and treasury, and funded by premiums collected from pension plans. If an employer is unable to meet pension obligations, the PBGC may make the payments for the employer. PBGC covers only defined benefit pension plans, with the exception of church-based pension plans. Religious organizations are excepted because courts and legislatures consider church-based pensions to be an ecclesiastical matter beyond the authority of the law.

An employee cannot lose pension benefits by retiring early. Under defined benefit plans, the employee may begin to receive pension benefits upon reaching the normal retirement age of 65 years. If an employee retires before reaching age 59.5 and begins drawing from his pension, his pension payments are taxed at a 10 percent annual rate in addition to any regular income taxes. This excise tax is levied because pension funds are designed to promote security after retirement.

The excise tax does not apply to a pension given to a surviving spouse when the employee dies before the pension is fully paid, even if the employee dies before reaching age 59.5. Employees who become disabled before age 59.5 do not have to pay the excise tax, nor do persons who specifically choose to receive the pension payments as an ANNUITY or periodically. In addition, the excise tax does not apply to pensions of employees over the age of 55 years who have separated from their employer, certain pensions paid for medical expenses, and pension payments made pursuant to certain divorce-related court orders.

ERISA does not regulate pension plans with 25 or fewer participants or plans that are solely for business partners or a sole proprietor. Employees of businesses not covered by ERISA may look to state statutes governing pensions that contain regulations and requirements similar to those in ERISA.

Congress refined the tax consequences of pensions in January 1996. Under the Pension Source Act (Pub. L. No. 104-95, amending title 4 of U.S.C.A. § 114), a state that imposes income taxes may not tax pension benefits earned in the state if the pensioner is living in a state that does not impose personal INCOME TAX.

Pensions are an attractive component of employee compensation packages. The money that the employer withholds during the working life of the employee is not taxed, and the money in a pension fund can be increased through investments. When the pensioned employee retires, she or he can ask for the entire pension in one lump sum or can take the pension as an annuity, which is a series of payments that lasts for a specified period of time. If the retiree lives long enough, she or he will receive more money than the employer originally withheld. If the pensioner dies before the pension is fully paid, her or his surviving spouse or another designated survivor may receive the remainder of the pension. A retiree who has worked at several companies may receive several pensions.

Individuals who are self-employed have their own pension options. A self-employed worker may establish a KEOGH PLAN, which is a type of retirement plan for self-employed workers that is comparable to a pension plan. Under a Keogh plan, the worker makes tax-free payments into a fund and receives larger payments upon retirement.

An INDIVIDUAL RETIREMENT ACCOUNT (IRA) is another way to provide for security in retirement. An IRA is a personal retirement account that workers may establish in addition to, or instead of, a pension. Employers may establish similar personal retirement accounts for their employees. These accounts are called 401K plans, after the section of the INTERNAL REVENUE CODE that authorizes them. Under a 401K plan, a worker deposits a portion of his or her gross earnings into the account to avoid income tax on that portion of the earnings. The earnings are subject to taxation when the retiring worker receives them. If the worker is in a lower tax bracket by retirement, he or she will end up paying less tax on the portion of the earnings in the IRA.

Pension benefits are distinct from other retirement benefits such as SOCIAL SECURITY and medical assistance. A pension may reduce slightly the amount of Social Security benefits that a government employee receives.