What are Pension Funds?

Pension funds play a crucial role in securing retirement income for employees. While many private employers have moved toward defined-contribution plans like 401(k)s, public sector employees and some private workers still benefit from traditional pensions. These plans offer a predictable income stream, providing financial stability in retirement. Here’s a comprehensive breakdown of how pension funds operate.

How pension funds generate retirement income

Pension funds are most commonly structured as defined-benefit plans. These plans promise retirees a specific payout based on a formula that considers factors like their average salary during their final working years and total years of service.

For instance, if your pension pays 1% of your average salary over the last five years of your employment, and you worked 30 years with an average salary of $50,000, you would receive $15,000 annually in retirement benefits.

Types of Pension Funds

• Single-employer plans: Funded and maintained by one employer, common in private-sector companies.
• Multi-employer plans: Managed by multiple employers within an industry, often seen with unionized workers.
• Public sector pension plans: Offered to government employees and generally more generous, sometimes including cost-of-living adjustments.

Defined Benefit Versus Defined Contribution Plans

Pensions generally fall into two categories, and understanding the difference is essential when planning your retirement. How your pension fund operates — and how you should approach investing in it — will depend on which type you have. Below is a breakdown of the two primary types:

Defined benefit plan

Often referred to as a “traditional pension,” a defined benefit plan guarantees a specific payout during retirement. Your benefits are pre-determined by a formula, typically based on your salary history and years of service.

• Guaranteed income: You’ll know exactly how much you’ll receive each month.
• Employer-funded: The employer is responsible for contributing and managing the fund to meet payout obligations.
• Declining availability: These plans are becoming less common as employers shift the financial risk to employees through other retirement plans.

Since the payout is promised regardless of market conditions, employers bear the investment risk — a key reason defined benefit plans are phasing out in favor of alternatives.

Defined contribution plan

The most common example of this type is a 401(k) plan. In defined contribution plans, both you and your employer contribute to your retirement savings, but there’s no guaranteed payout amount at retirement.

• Employer and employee contributions: Both parties contribute, but the payout depends on how investments perform.
• No promised amount: Retirement income is based on your contributions, investment returns, and market performance.
• More popular today: Many employers offer defined contribution plans, sometimes alongside traditional pensions.

With defined contribution plans, employees assume the investment risk — but they also gain greater control over how their funds are invested.

How Pensions are Funded and Insured

Private pensions are regulated by the Employee Retirement Income Security Act (ERISA) of 1974. This legislation aims to ensure that pensions are well-funded and provide protections for beneficiaries. Employers fund these plans, and in some cases, employees also contribute.

The Pension Benefit Guaranty Corporation (PBGC) insures private pensions to protect beneficiaries if the plan becomes insolvent. Employers pay annual premiums to the PBGC for each plan participant. However, the PBGC may not cover the entire promised pension if a plan fails, with limits set on the payout amount.

• 2024 PBGC cap for single-employer pensions: $7,107.95 per month for a 65-year-old retiree.
• Multi-employer plan cap: Up to $12,870 annually for 30 years of service.

Public vs. Private Pension Plans

Public sector pension plans, such as those offered by the California Public Employees’ Retirement System (CalPERS), tend to offer more generous benefits compared to private pensions.

• Public plans often include a cost-of-living adjustment (COLA) to offset inflation.
• Private plans rarely offer COLAs, meaning the value of payouts may erode over time.
• Public pensions are not insured by the PBGC. Instead, taxpayers cover the cost if a public pension fund faces shortfalls.

Regulations Governing Pension Funds

Private pensions are regulated by the Employee Retirement Income Security Act (ERISA), overseen by the Department of Labor’s Employee Benefits Security Administration. ERISA ensures that pension plans meet strict standards, safeguarding the retirement savings of participants.

• Employer accountability: Companies must adhere to regulations ensuring pension funds are managed responsibly.
• Qualified plan administrators: Those managing the funds must meet specific qualifications and act in the best interest of employees.

The role of the Pension Benefit Guaranty Corporation (PBGC)

The Pension Benefit Guaranty Corporation (PBGC) offers additional protection to retirees. If a private pension plan runs into financial trouble, the PBGC steps in to help safeguard retirement benefits.

• Missing pensions assistance: The PBGC provides a pension search directory to help individuals locate lost pensions.
• Guidance on payouts: If you find a missing pension, the PBGC offers support in claiming your benefits, ensuring you receive what you’re entitled to.

These safeguards ensure that both private employers and administrators meet their obligations, providing future retirees with confidence that their pension will be there when they need it. For public pensions, however, different rules apply, and these plans are generally regulated at the state level.

How Pension Funds Invest

Pension funds manage their assets to ensure they meet their future obligations to retirees. ERISA requires private pension fund managers to act as fiduciaries, meaning they must prioritize the financial interests of plan participants.

Typical pension fund investments include:

• Bonds for stability and predictable returns.
• Stocks to provide long-term growth.
• Real estate as an additional asset class for diversification.

In recent years, pension funds have also embraced alternative investments, such as private equity and hedge funds, to increase potential returns.

Challenges Facing Pension Funds

While pensions remain a reliable income source for many, some funds are under financial pressure. The shift from defined-benefit plans to defined-contribution plans like 401(k)s reflects the challenges employers face in maintaining pensions.

• Multi-employer pension plans have struggled with funding shortfalls, prompting legislative action such as the American Rescue Plan Act of 2021, which provides financial assistance to stabilize these plans.
• Many state and local government pension funds are not fully funded. As of 2023, public pensions were funded at an average of 78.1%, with a total of $1.44 trillion in unfunded liabilities.

Why Pension Fund Health Matters

The financial stability of a pension fund determines whether it can meet its obligations to retirees over the long term. For beneficiaries, understanding the health of the pension plan they are enrolled in can offer peace of mind — or serve as a signal to plan supplemental savings.

State and local pensions face additional pressure from demographic changes, such as retirees living longer, and economic factors, including inflation and investment returns.

Have questions about how your pension plans fit into your retirement? Sit down with an expert financial advisor from Retirable today to get advice customized to your needs.

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