Pension Plans
There are two
types of pension plans: defined benefit plans and defined contribution plans.
Defined benefit
plans are plans that promise participants a level of retirement income that is
determined according to a formula. The formula might be based on years of
service and a final average salary, for example.
Under a defined
benefit plan, an employee can determine what his or her expected monthly
pension benefit will be by putting his or her individual information, such as
actual years of service and actual final average salary, into the formula. This
amount is promised to the employee by the company. The risk of investment loss
is on the company.
Defined
contribution plans, or individual account plans, do not promise a specific
level of retirement income. Rather, each participant has an account in the plan
to which employer contributions are allocated. These plans are generally the
only type of retirement plan provided for at smaller major, national and
regional carriers.
A defined
contribution plan participant's
retirement benefit is the value of this account at retirement. This will be
determined mainly by the history of salary deferral contributions from the
employee, and possibly a matching contribution from the employer, and the
investment experience of the monies contributed.
In a defined
contribution plan, the employer is not promising that a participant's account will have enough
money to fund any specific benefit level. The employer's only obligation is to make the promised
contributions, if any. The risk of investment losses is on the employee.
The precarious
nature of defined contribution plans was dramatically illustrated by the Enron
failure. There were many stories reported of employees who had hundreds of
thousands of dollars in their 401(k) accounts
before the collapse, but next to nothing after the collapse.
Enron represents the extreme case, but it illustrates dramatically the reality
of the risk of investment loss.
Page 3 Pension Funding Crisis? ð
401(k)
plans are popular defined contribution plans. The name comes from the section of
the Internal Revenue Code of 1986 (the "Code") that authorizes these
pension plan accounts. Section 401(k) is entitled:
"Cash or Deferred Arrangements".
One
of the problems with Enron 401(k) accounts was that the employer contributions were
made with Enron stock. When the stock price fell precipitously, the value of
participants' accounts
plummeted as well. The Enron plan also prohibited participants from selling the
Enron stock and diversifying their account holdings. The latter problem has
been addressed in legislation post-Enron.
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