Pension

A retirement plan is an arrangement to provide people with an income during retirement when they are no longer earning a steady income from employment. Often retirement plans require both the employer and employee to contribute money to a fund during their employment in order to receive defined benefits upon retirement. It is a tax deferred savings vehicle that allows for the tax-free accumulation of a fund for later use as a retirement income. Funding can be provided in other ways, such as from labor unions, government agencies, or self-funded schemes. Pension plans are therefore a form of "deferred compensation". A SSAS is a type of employment-based Pension in the UK. The 401(k) is the iconic self-funded retirement plan that many Americans rely on for much of their retirement income; these sometimes include money from an employer, but are usually mostly or entirely funded by the individual using an elaborate scheme where money from the employee's paycheck is withheld, at their direction, to be contributed by their employer to the employee's plan. This money can be tax-deferred or not, depending on the exact nature of the plan.

Some countries also grant pensions to military veterans. Military pensions are overseen by the government; an example of a standing agency is the United States Department of Veterans Affairs. Ad hoc committees may also be formed to investigate specific tasks, such as the U.S. Commission on Veterans' Pensions (commonly known as the "Bradley Commission") in 1955–56. Pensions may extend past the death of the veteran himself, continuing to be paid to the widow.

Many countries have created funds for their citizens and residents to provide income when they retire (or in some cases become disabled). Typically this requires payments throughout the citizen's working life in order to qualify for benefits later on. A basic state pension is a "contribution based" benefit, and depends on an individual's contribution history. For examples, see National Insurance in the UK, or Social Security in the United States of America.

Many countries have also put in place a "social pension". These are regular, tax-funded non-contributory cash transfers paid to older people. Over 80 countries have social pensions.[4] Some are universal benefits, given to all older people regardless of income, assets or employment record. Examples of universal pensions include New Zealand Superannuation[5] and the Basic Retirement Pension of Mauritius.[6] Most social pensions, though, are means-tested, such as Supplemental Security Income in the United States of America or the "older person's grant" in South Africa.[7]

Some pension plans will provide for members in the event they suffer a disability. This may take the form of early entry into a retirement plan for a disabled member below the normal retirement age.

Defined benefit plans may be either funded or unfunded.

In an unfunded defined benefit 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.[15] The social security systems of many European countries are unfunded,[16] having benefits paid directly out of current taxes and social security contributions, although several countries have hybrid systems which are partially funded. Spain set up the Social Security Reserve Fund and France set up the Pensions Reserve Fund; in Canada the wage-based retirement plan (CPP) is partially funded, with assets managed by the CPP Investment Board while the U.S. Social Security system is partially funded by investment in special U.S. Treasury Bonds.

In a funded plan, contributions from the employer, and sometimes also from plan members, are invested in a fund towards meeting the benefits. All plans must be funded in some way, even if they are pay-as-you-go, so this type of plan is more accurately known as pre-funded. The future returns on the investments, and the future benefits to be paid, are not known in advance, so there is no guarantee that a given level of contributions will be enough to meet the benefits. Typically, the contributions to be paid are regularly reviewed in a valuation of the plan's assets and liabilities, carried out by an actuary 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. If a plan is not well-funded, the plan sponsor may not have the financial resources to continue funding the plan.

Traditional defined benefit plan designs (because of their typically flat accrual rate and the decreasing time for interest discounting as people get closer to retirement age) tend to exhibit a J-shaped accrual pattern of benefits, where the present value of benefits grows quite slowly early in an employee's career and accelerates significantly in mid-career: in other words it costs more to fund the pension for older employees than for younger ones (an "age bias"). Defined benefit pensions tend to be less portable than defined contribution plans, even if the plan allows a lump sum cash benefit at termination. Most plans, however, pay their benefits as an annuity, so retirees do not bear the risk of low investment returns on contributions or of outliving their retirement income. The open-ended nature of these risks to the employer is the reason given by many employers for switching from defined benefit to defined contribution plans over recent years. The risks to the employer can sometimes be mitigated by discretionary elements in the benefit structure, for instance in the rate of increase granted on accrued pensions, both before and after retirement.

The age bias, reduced portability and open ended risk make defined benefit plans better suited to large employers with less mobile workforces, such as the public sector (which has open-ended support from taxpayers). This coupled with a lack of foresight on the employers part means a large proportion of the workforce are kept in the dark over future investment schemes.

Defined benefit plans are sometimes criticized as being paternalistic as they enable employers or plan trustees to make decisions about the type of benefits and family structures and lifestyles of their employees. However they are typically more valuable than defined contribution plans in most circumstances and for most employees (mainly because the employer tends to pay higher contributions than under defined contribution plans), so such criticism is rarely harsh.

The "cost" of a defined benefit plan is not easily calculated, and requires an actuary or actuarial software. However, even with the best of tools, the cost of a defined benefit plan will always be an estimate based on economic and financial assumptions. These assumptions include the average retirement age and lifespan of the employees, the returns to be earned by the pension plan's investments and any additional taxes or levies, such as those required by the Pension Benefit Guaranty Corporation in the U.S. So, for this arrangement, the benefit is relatively secure but the contribution is uncertain even when estimated by a professional. This has serious cost considerations and risks for the employer offering a pension plan.

One of the growing concerns with defined benefit plans is that the level of future obligations will outpace the value of assets held by the plan. This "underfunding" dilemma can be faced by any type of defined benefit plan, private or public, but it is most acute in governmental and other public plans where political pressures and less rigorous accounting standards can result in excessive commitments to employees and retirees, but inadequate contributions. Many states and municipalities across the United States of America and Canada now face chronic pension crises.

Many countries offer state-sponsored retirement benefits, beyond those provided by employers, which are funded by payroll or other taxes. In the United States, the Social Security system is similar in function to a defined benefit pension arrangement, albeit one that is constructed differently from a pension offered by a private employer; however, Social Security is distinct in that there is no legally guaranteed level of benefits derived from the amount paid into the program.

Individuals that have worked in the UK and have paid certain levels of national insurance deductions can expect an income from the state pension scheme after their normal retirement. The state pension is currently divided into two parts: the basic state pension, State Second [tier] Pension scheme called S2P. Individuals will qualify for the basic state pension if they have completed sufficient years contribution to their national insurance record. The S2P pension scheme is earnings related and depends on earnings in each year as to how much an individual can expect to receive. It is possible for an individual to forgo the S2P payment from the state, in lieu of a payment made to an appropriate pension scheme of their choice, during their working life. For more details see UK pension provision.

In the United States, the legal definition of a defined contribution plan is a plan providing for an individual account for each participant, and for benefits based solely on the amount contributed to the account, plus or minus income, gains, expenses and losses allocated to the account (see 26 U.S.C. § 414(i)). Examples of defined contribution plans in the United States include individual retirement accounts (IRAs) and 401(k) plans. In such plans, the employee is responsible, to one degree or another, for selecting the types of investments toward which the funds in the retirement plan are allocated. This may range from choosing one of a small number of pre-determined mutual funds to selecting individual stocks or other securities. Most self-directed retirement plans are characterized by certain tax advantages, and some provide for a portion of the employee's contributions to be matched by the employer. In exchange, the funds in such plans may not be withdrawn by the investor prior to reaching a certain age—typically the year the employee reaches 59.5 years old-- (with a small number of exceptions) without incurring a substantial penalty.

Advocates of defined contribution plans point out that each employee has the ability to tailor the investment portfolio to his or her individual needs and financial situation, including the choice of how much to contribute, if anything at all. However, others state that these apparent advantages could also hinder some workers who might not possess the financial savvy to choose the correct investment vehicles or have the discipline to voluntarily contribute money to retirement accounts.

In the US, defined contribution plans are subject to IRS limits on how much can be contributed, known as the section 415 limit. In 2009, the total deferral amount, including employee contribution plus employer contribution, was limited to $49,000 or 100% of compensation, whichever is less. The employee-only limit in 2009 was $16,500 with a $5,500 catch-up. These numbers usually increase each year and are indexed to compensate for the effects of inflation. For 2015, the limits were raised to $53,000 and $18,000,[23] respectively.

Examples of defined contribution pension schemes in other countries are, the UK's personal pensions and proposed National Employment Savings Trust (NEST), Germany's Riester plans, Australia's Superannuation system and New Zealand's KiwiSaver scheme. Individual pension savings plans also exist in Austria, Czech Republic, Denmark, Greece, Finland, Ireland, Netherlands, Slovenia and Spain[24]

• Canada: Healthcare of Ontario Pension Plan (HOOPP)
• US: State of Wisconsin Investment Board
• US: TIAA
• APAC/Europe: Tontine Trust
• UK: Royal Mail Pension Fund
• Netherlands: Stichting Pensioenfonds ABP
• Denmark: Arbejdsmarkedets Tillægspension

Hybrid plan designs combine the features of defined benefit and defined contribution plan designs.

A cash balance plan is a defined benefit plan made to appear as if it were a defined contribution plan. They have notional balances in hypothetical accounts where, typically, each year the plan administrator will contribute an amount equal to a certain percentage of each participant's salary; a second contribution, called interest credit, is made as well. These are not actual contributions and further discussion is beyond the scope of this entry suffice it to say that there is currently much controversy. In general, they are usually treated as defined benefit plans for tax, accounting and regulatory purposes. As with defined benefit plans, investment risk in hybrid designs is largely borne by the plan sponsor. As with defined contribution designs, plan benefits are expressed in the terms of a notional account balance, and are usually paid as cash balances upon termination of employment. These features make them more portable than traditional defined benefit plans and perhaps more attractive to a more highly mobile workforce.

Target benefit plans are defined contribution plans made to match (or resemble) defined benefit plans.

Advocates of defined contribution plans point out that each employee has the ability to tailor the investment portfolio to his or her individual needs and financial situation, including the choice of how much to contribute, if anything at all. However, others state that these apparent advantages could also hinder some workers who might not possess the financial savvy to choose the correct investment vehicles or have the discipline to voluntarily contribute money to retirement accounts. This debate parallels the discussion currently going on in the U.S., where many Republican leaders favor transforming the Social Security system, at least in part, to a self-directed investment plan.

As part of Otto von Bismarck's social legislation, the Old Age and Disability Insurance Bill was enacted and implemented in 1889.[30] The Old Age Pension program, financed by a tax on workers, was originally designed to provide a pension annuity for workers who reached the age of 70 years, though this was lowered to 65 years in 1916. Unlike accident insurance and health insurance, this program covered industrial, agrarian, artisans and servants from the start and was supervised directly by the state.[31]

Germany's mandatory state pension provisions are based on the pay-as-you-go (or redistributive) model. Funds paid in by contributors (employees and employers) are not saved and neither invested but are used to pay current pension obligations.

Recently, the German government has come under criticism for the impending disaster posed by the exorbitant tax burden resulting from civil servants' pensions. A study, commissioned by the Taxpayers Association, that Professor Bernd Raffelhüschen of the Generation Contracts Research Center of the University of Freiburg carried out states that by 2050, the state will have to spend 1.3 to 1.4 trillion EUR to supply its civil servants. The majority of it, about 870 billion EUR, is therefore spent on pensions.[32][33]

The federal government's financial statements for 2016 already show the extent of that disaster. According to this, the expected costs for pensions and subsidies for medical treatment for the number of federal civil servants at the end of 2016 will amount to 647 billion EUR over the course of the next ten years. That is 63 billion EUR more than in the previous year - an increase of ten percent in just one year.

The sum is divided into:

• Pension obligations of EUR 477.96 billion (plus 9.7 percent) and

• Aid obligations of EUR 169.02 billion (plus 13.4 percent).[32] [33]

Officials, judges and soldiers account for 238.4 billion EUR of the expected pension expenditure of almost 478 billion EUR. In addition, there are legacy issues from the times of large state-owned companies: the federal government has to pay out 171 billion EUR for old-age pensions for former postal officials and 68.5 billion EUR for former railway officials.

The problem: while the government preaches private pension provision to workers, the state itself has failed to build adequate reserves for the wave of pensions in the coming years. The federal government has been trying to create a cushion since 2007. So far, however, this has only amounted to 14 billion EUR by 2018. Professor Bernd Raffelhüschen criticised that the state had made high pension commitments for decades, "but initially didn't build up any reserves for a long time."

Pensions, thus, represent a considerable burden for public budgets. As Professor Bernd Raffelhüschen calculated in his study in 2005, the present value of the pension burden for the federal states amounts to 1,797 billion EUR, which is larger than the Germany's total public debt.

In various federal states, efforts are being made to secure pension expenditure by setting up pension funds for newly hired civil servants. Fiscal relief is, however, only to be expected when the newly hired officials retire. The share of tax revenue needed to supply for the pensions will increase from approximately 10% in 2001 in many federal states to over 20% in 2020. In the extreme case of the city-state of Hamburg, every fourth euro of income will be used to finance pensions for their retired civil servants.

There is a history of pensions in Ireland that can be traced back to Brehon Law imposing a legal responsibility on the kin group to take care of its members who were aged, blind, deaf, sick or insane.[34] For a discussion on pension funds and early Irish law, see F Kelly, A Guide to Early Irish Law (Dublin, Dublin Institute for Advanced Studies, 1988). In 2010, there were over 76,291 pension schemes operating in Ireland.[35]

Public sector workers in Leeds striking over pension changes by the government in November 2011

The decline of Feudal systems and formation of national states throughout Europe led to the reemergence of standing armies with their allegiances to states. Consequently, the sixteenth century in England marked the establishment of standardised systems of military pensions. During its 1592–93 session, Parliament established disability payments or “reliefe for Souldiours ... [who] adventured their lives and lost their limbs or disabled their bodies” in the service of the Crown. This pension was again generous by contemporary standards, even though annual pensions were not to exceed ten pounds for “private soldiers,” or twenty pounds for a “lieutenant.” [26]

The beginning of the modern state pension came with the Old Age Pensions Act 1908, that provided 5 shillings (£0.25) a week for those over 70 whose annual means do not exceed £31.50. It coincided with the Royal Commission on the Poor Laws and Relief of Distress 1905-09 and was the first step in the Liberal welfare reforms to the completion of a system of social security, with unemployment and health insurance through the National Insurance Act 1911.

In 1921, The Finance Act introduced tax relief on pension contributions in line with savings and life insurance. As a consequence, the overall size of the fund was increased since the income tax was now added to the pension as well.[36]

Then in 1978, The State Earnings-Related Pension Scheme (SERPS) replaced The Graduated Pension Scheme from 1959, providing a pension related to earnings, in addition to the basic state pension. Employees and employers had the possibility to contribute to it between 6 April 1978 and 5 April 2002, when it was replaced by the State Second Pension.

After the Second World War, the National Insurance Act 1946 completed universal coverage of social security, introducing a State Pension for everybody on a contributory basis, with men being eligible at 65 and women at 60.[36][37] The National Assistance Act 1948 formally abolished the poor law, and gave a minimum income to those not paying National Insurance.

The early-1990s established the existing framework for state pensions in the Social Security Contributions and Benefits Act 1992 and Superannuation and other Funds (Validation) Act 1992. Following the highly respected Goode Report, occupational pensions were covered by comprehensive statutes in the Pension Schemes Act 1993 and the Pensions Act 1995.

In 2002, the Pensions Commission was established as a cross-party body to review pensions in the United Kingdom. The first Act to follow was the Pensions Act 2004 that updated regulation by replacing OPRA with the Pensions Regulator and relaxing the stringency of minimum funding requirements for pensions while ensuring protection for insolvent businesses. In a major update of the state pension, the Pensions Act 2007, which aligned and raised retirement ages. Following that, the Pensions Act 2008 has set up automatic enrolment for occupational pensions, and a public competitor designed to be a low-cost and efficient fund manager, called the National Employment Savings Trust (or "Nest").

First "American" pensions came in 1636, when Plymouth colony, and subsequently, other colonies such as Virginia, Maryland (1670s) and NY (1690s), offered the first colonial pension. The general assembly of the Virginia Company followed by approving a resolution known as Virginia Act IX of 1644 stating that "...all hurt or maymed men be relieved and provided for by the several counties, where such men reside or inhabit."[38] Furthermore, during King Philip's War, otherwise known as the First Indian War, this Act was expanded to widows and orphans in Virginia's Act of 1675.[39][40]

Public pensions got their start with various 'promises', informal and legislated, made to veterans of the Revolutionary War and, more extensively, the Civil War. They were expanded greatly, and began to be offered by a number of state and local governments during the early Progressive Era in the late nineteenth century.[41][42]

Federal civilian pensions were offered under the Civil Service Retirement System (CSRS), formed in 1920. CSRS provided retirement, disability and survivor benefits for most civilian employees in the US Federal government, until the creation of a new Federal agency, the Federal Employees Retirement System (FERS), in 1987.

Pension plans became popular in the United States during World War II, when wage freezes prohibited outright increases in workers' pay. The defined benefit plan had been the most popular and common type of retirement plan in the United States through the 1980s; since that time, defined contribution plans have become the more common type of retirement plan in the United States and many other western countries.

In April 2012, the Northern Mariana Islands Retirement Fund filed for Chapter 11 bankruptcy protection. The retirement fund is a defined benefit type pension plan and was only partially funded by the government, with only $268.4 million in assets and $911 million in liabilities. The plan experienced low investment returns and a benefit structure that had been increased without raises in funding.[43] According to Pensions and Investments, this is "apparently the first" US public pension plan to declare bankruptcy.[43]

This non-contributory pillar was introduced only recently, aiming to alleviate poverty among the elderly, and permitting fiscal conditions. It is usually financed by the state and is in form of basic pension schemes or social assistance. [47][48] In some typologies, the zero and the first pillar overlap.[46]

Pillar 1, sometimes referred to as the public pillar or first-tier, answers the aim to prevent the poverty of the elderly, provide some absolute, minimum income based on solidarity and replace some portion of lifetime pre-retirement income. It is financed on a redistributive principle without constructing large reserves and takes the form of mandatory contributions linked to earnings such as minimum pensions within earnings-related plans, or separate targeted programs for retirement income. These are provided by the public sector and typically financed on pay-as-you-go basis.

Pillar 2, or the second tier, built on the basis of defined benefit and defined contribution plans with independent investment management, aims to protect the elderly from relative poverty and provides benefits supplementary to the income from the first pillar to contributors. [49] Therefore, the second pillar fulfils the insurance function. In addition to DB's and DC's, other types of pension schemes of the second pillar are the contingent accounts, known also as Notional Defined Contributions (implemented for example in Italy, Latvia, Poland and Sweden) or occupational pension schemes (applied, for instance, in Estonia, Germany and Norway).[49]

The third tier consists of voluntary contributions in various different forms, including occupational or private saving plans, and products for individuals.

The fourth pillar is usually excluded from classifications since it does not usually have a legal basis and consists of "informal support (such as family), other formal social programs (such as health care or housing), and other individual assets (such as home ownership and reverse mortgages)." [48][50]

These 5 pillars and their main criteria are summarised in the table below by Holzmann and Hinz.

Multipillar Pension Taxonomy: [48]