A pension is a steady income provided to a person usually after his retirement made in the form of guaranteed annuity payments to a retired employee. Some other types of retirement plans are designed in such a way that accumulated cash balance is provided to the retired employee. This cash accumulation is made by adopting different mechanisms so that the employee can draw up this lump sum amount on retirement. In this case, the employee is not provided with any annuity payments. These plans are also referred to as pension plans. In both the cases of pension plans when the employers created the plans for providing retirement benefits to the employees, the plans are treated as ‘employer pension plans.
A defined benefit plan is distinct from a defined contribution plan. The pension plan which provides for a definite retirement benefit for the employee is called a defined benefit plan. This is the traditional type of pension plan usually provided by employers. The defined pension amount is calculated based on the employee’s pay, years of employment, employee’s age at retirement, and other factors. In the United States, the pension amount is determined based on the average pay for the last five or three years of an employee’s tenure of employment. The pension amounts are calculated after considering the possible benefits under Social Security schemes. The retirement plans also ensure that the employees get incentives if they retire early or continue to work after he retires.
The alternative to a definite benefit plan is the defined contribution plan. “A retirement plan in which a certain amount or percentage of money is set aside each year by a company for the benefit of the employee.” (Investopedia, 2009) A defined-contribution plan is a pension plan designed to provide a pension for an individual employee. “In the United States, the legal definition of a defined contribution plan is a plan providing for an individual account for each participant, and benefits based solely on the amount contributed to the account, plus or minus income, gains, expenses, and losses allocated to the account.” (Trikore, 2008)
The contributions to the defined contribution plans are paid into individual accounts of each employee eligible under the plan. The contributions made by the employer to the pension funds get invested in different types of securities. The returns from such investments are added to the individual pension fund accounts of the employees. On the retirement of the employee, the funds in the account of the employee are utilized to provide for the retirement benefits usually in the form of purchase of an annuity which is expected to provide regular income to the employee.
Defined contribution plans have gained popularity across the world and are the dominant form of pension plans for employees in the private sector in many countries. In the United States, defined benefit plans have slowly been losing popularity among employers as more employers look at the defined benefit plans as burdensome expenses. The employers find the defined contribution plan as more advantageous to both the employers and employees.
In the given example of the Assistant Professor the retirement benefits out of the two types of pension plans can be calculated as below:
Defined Benefit Plan
Formula for calculating the retirement pension is:
No of years of service x 1.5% x salary at retirement
40 x $ 326203.80 (From the Statement) x 1.5% = $ 195,722.30
Defined Contribution Plan
The future value of the annual contribution at 8% of the salary every year is calculated using the excel function and the values are presented in the following table.
|Years to Retirement||Salary||Contribution||Future Value at Retirement|
From the statement, it can be observed that the total contribution by the employer throughout service is $ 629,306.38 and the future value of such contributions is $ 2,011,456.56.
Comparing the number of pensions as calculated under both the pension plans it can be seen that the defined contribution plan is a better pension plan for the assistant professor, as in this case both the total amount of contribution as well as the future value of the contribution is more than the retirement benefit under the state’s definite benefit plan.
Investopedia. (2009). Defined-Contribution Plan. Web.
Trikore. (2008). Retirement Planning. Web.