Pension Systems Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A pension is an income given to an individual after retirement. Different systems exist to provide and fund this pension, both private (generally employer-pro-vided) and public (provided by the government). In the United States, Social Security is the closest analogue to a public pension system, though it is not traditionally referred to that way (notably, Social Security pays out at a given age instead of upon retirement, and as a social welfare program, it includes disability benefits).

Pensions typically work like annuities, in that money is paid in during the deferral phase and paid out in periodic checks during the annuity phase. In the United States, employer-provided pension plans became more common during World War II, when scarcity of funds led to wage freezes and an increase in benefits such as pensions became the alternative to giving an employee a raise. Pension plans also encourage employee loyalty, since the eventual benefits increase the longer the employee works for the company, such that career moves that are lateral in salary and current benefits will generally be a step down in terms of overall benefits. The longer an employee has worked for a company, the more he or she has to lose by leaving for another position, which thus gives the greatest motivation to the most experienced workers.

Defined Benefit And Defined Contribution

In addition to the question of whether they are private or public, pension plans can be defined benefit or defined contribution, or a hybrid of the two. In the United States, it is typical to refer only to the defined benefit plan as a pension, but defined contribution plans have become the most common type of privately funded retirement plan in the country.

Defined contribution plans accrue from contributions paid into the plan over time, which are invested in stocks or mutual funds, with the returns of those investments affecting the individual’s account balance. When the market as a whole takes a significant dip, part of the resulting panic is because of the number of people whose retirement plans are thus so influenced by market performance. Common defined contribution plans include the 401(k) and the Individual Retirement Account (IRA). The 401(k) is an employer sponsored salary reduction plan: employees define a percentage of their paycheck to be diverted into the 401(k) account instead of disbursed to them, and any such earnings are tax deferred (taxed not in the year they were earned, but in the year they are disbursed as benefits, further down the line). Some employers will match the employee’s contribution, in whole or in part, the specifics of which are agreed-upon when the plan is set up and signed. Defined contribution plans have the benefit of protecting employees from employer bankruptcy, a protection not offered by employer-sponsored defined benefit plans, which may be used to pay off an employer’s debts in case of bankruptcy; while the Pension Benefit Guaranty Corporation, a federal agency created by the 1974 Employee Retirement Income Security Act (ERISA), ensures defined benefit pension plans, it does so with a cap on the maximum benefits, especially for benefits paid to early retirees (a great number of which can be expected when an employer goes bankrupt) and benefits paid to survivors of deceased employees.

A 401(k) plan remains active for the rest of the employee’s life, but must begin paying out by April 1 of the calendar year after the employee turns 70 1/2, unless the employee is still working. Similar plans are the 403(b) for employees of public schools, self-employed ministers, and employees of 501(c)(3) nonprofits; and the 457 plan, for government employees.

IRAs are another creation of ERISA and come in various types. The most common are the traditional IRA, which is funded by “before-tax” money like the 401(k), and the Roth IRA, which is funded with after-tax money and is therefore tax-exempt when it pays out. IRAs are protected from bankruptcy by both state and federal laws; some states protect IRAs from seizure to satisfy lawsuits, but they are usually not protected from IRS fines for failure to pay taxes, or divorce settlements.

Defined benefit plans are what most Americans mean by pension plans. Instead of paying out according to investment earnings, like a defined contribution plan, a defined benefit pays out a specific monthly amount determined by a particular formula. Sometimes this is a flat amount multiplied by the employee’s length of employment with the company (another demotivator for changing jobs later in life). Other times, the benefit is determined according to the employee’s salary in the years leading up to retirement, without consideration of the length of his employment; because this approach benefits recently hired executives more than it does lowerwage workers of lengthy service, it is not favored by labor unions.

Retiring early leads to a reduced payment from the defined benefit plan, on the assumption that it will be paid out for a long period of time. Despite this, because companies can hire young employees for less money, there are often incentives built into the pension plan to encourage early retirement. Unlike defined contribution plans, defined benefit plans are bound to an employer—if you leave the job before you are old enough to draw on your pension fund, you do not receive the pension. This is one reason defined contribution plans have risen in popularity in the last 30 years.

Social Security

Social Security is essentially a defined benefit plan. All workers and self-employed individuals pay into the Social Security system; employers further pay a payroll tax. These taxes are paid into the Social Security Trust Fund maintained by the U.S. Treasury. Unlike individual plans, current Social Security outgo is paid out by current Social Security income; the current generations of employees are funding the benefits of the current generation of retirees. The money that is left over is then invested in government bonds, funding the federal government’s deficit spending. Congress grants the trust fund the authority to pay out Social Security payments only to the extent of the revenue collected and its holdings in bonds—in other words, should the total of payments owed exceed the total of revenues collected, the trust fund would be unable to issue its payments in full, rather than borrowing from some other source in the federal government. (Depending on the circumstance, a bailout seems likely, followed by a longer-term legislative solution.)

Social Security comes under criticism for a number of reasons. It was introduced as part of President Franklin Roosevelt’s New Deal legislation, and the circumstance in which it was introduced—an economic crisis coupled with a rarity of employer-provided retirement benefits—no longer obtains, though it is true that a new economic crisis has arisen in the 21st century, and that not every American’s employer provides a pension. Social Security is also criticized for being inefficient; excess revenue is stored in bonds instead of enjoying greater growth through low-risk investments. Social Security is not guaranteed to the degree that private plans are, insofar as the trust fund is limited. Further, the Social Security number has been adopted as a sort of identification number by many public and private agencies, though this is frowned upon by the Social Security Administration and theoretically restricted by the 1974 Privacy Act. Perhaps the biggest problem is that the tax to fund Social Security is regressive—only wages below $102,000 are taxed, such that upper-class earners pay a substantially lower percentage of their wages.

Bibliography:

Franco Modigliani, Rethinking Pension Reform (Cambridge, 2004);
Robert J. Myers, Social Security (University of Pennsylvania Press, 1993).

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