Business, Legal & Accounting Glossary
A pension (also known as superannuation) is a retirement plan intended to provide a person with a secure income for life. Although a lottery may provide a pension, the common use of the term is to describe the payments a person receives upon retirement.
Pensions have traditionally been payments made in the form of a guaranteed annuity to a retired or disabled employee, or to a deceased employee’s spouse, children, or other beneficiary. A pension created by an employer for the benefit of an employee is commonly referred to as an occupational or employer pension. Labor unions, the government, or other organizations may also sponsor pension provision.
A pension plan that provides a guaranteed benefit is commonly called a defined benefit pension plan. The benefit in a defined benefit pension plan is determined by a formula based on the employee’s pay, years of employment and age at retirement to calculate the guaranteed payment. The United States Social Security system is an example of a defined benefit pension arrangement.
Defined benefit pension plans formerly dominated pension provision in both the private and public sector. However, a guaranteed, or “defined” benefit is no longer the universal pension payment model. Instead, the benefit may be based solely on the value of the accumulated assets in a pension fund at the time payment is to begin.
A pension of this kind is commonly called a defined contribution plan. In a defined contribution pension, the employer, the employee or both make contributions into an individual investment fund. This fund is invested in underlying investments, such as company shares, and will move in line with the return on these investments. At retirement, and occasionally in other circumstances, the individual draws income from the fund. Purchasing an annuity, which provides a secure income for life, from an insurance company, often does this.
In a defined contribution plan, investment risk and investment rewards are assumed by each individual/employee/retiree and not by the sponsor/employer. In the United States, the most common example of a defined contribution employer pension is the 401(k) Plan. As an incentive to encourage workers to contribute more to defined contribution plans, some governments have instituted significant tax advantages for doing so. The widespread use of defined contribution plans helps to alleviate the burden on state-sponsored pensions, such as Social Security.
There are various ways in which a pension may be financed. In a funded pension, contributions are paid into a fund during an individual’s working life. The fund will be invested in assets, such as stocks, bonds and property, and grow in line with the return on these assets.
In an unfunded pension no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid. Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly from current workers’ contributions and taxes. This method of financing is known as Pay-as-you-go. It has been suggested that this model bears a disturbing resemblance to a Ponzi scheme.
In a funded defined benefit arrangement, if the employee’s contributions and accumulated earnings are not sufficient to pay the guaranteed or “defined” benefit, the sponsor must cover the shortfall with additional contributions. Sponsors employ actuaries to calculate the contributions that need to be made to ensure that the pension fund will meet future payment obligations. This means that in a defined benefit pension, investment risk and investment rewards are typically assumed by the sponsor/employer and not by the individual.
A growing challenge for many nations is population ageing. As birth rates drop and life expectancy increases and ever larger portion of the population is elderly. This leaves fewer workers for each retired person. In almost all developed countries this means that the pension system will eventually go broke unless reformed. The three exceptions are Australia, Canada, and the United Kingdom where the pension system will be solvent for the foreseeable future. In Canada, for instance, the annual payments were increased by some 70% in 1998 to achieve this. These three nations also have an advantage from their relative openness to immigration.
Many employers now offer retirement accounts such as 401(k) plans instead of pensions.
She had worked for the company for thirty years, but when she retired, her pension only covered half of her living expenses.
Many old people depend on their pension to pay the bills.
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This glossary post was last updated: 14th February, 2020