PENSIONS/PENSION FUNDS

A pension plan is an agreement calling for an employer or an employee organization such as a labor union to contribute benefits to retired employees or retired members of the organization. These benefits usually come from an annuity, which is an investment program that yields fixed payments. There are both contributory and noncontributory pension plans. In the former, both employee and employer contribute to the plan. In the latter, only the employer contributes. Another distinction is between the defined contribution plan and the defined benefit plan. Defined contribution plans operate by having contributions invested for employees who in turn "own" a share of the value of the investments. The retirement benefits thus rise and fall with the value of the fund. Under a defined benefit plan, employee benefits are predetermined and usually based on the earnings and years of service of the employee.

In the United States there are a plethora of pension plans entailing a wide variety of benefit packages. Most pension plans, however, are characterized by two features—vesting and income deferral. Income deferral means that employees cannot begin receiving pension benefits until they retire or if their pension is vested, resign. Vesting refers to the legally binding nonforfeitable right of an employee to receive a pension. Vesting is generally related to length of employment. In order for one's pension to be vested, the participant must be employed by the company or organization for a specified number of years. The percentage of the total benefit package the employee is entitled to is also usually related to length of employment. Generally the longer a participant is employed, the greater the pension benefit up to a predetermined maximum. Once a pension is vested, it is nonforfeitable whether or not the employee continues to work, retires from the workforce, or leaves for another job. To be eligible for a pension plan, employees are usually required to work 1,000 hours a year, and their income must be subject to Social Security taxes.

The idea of quitting work once one reaches a certain age and still continue to receive benefits is a late 19th-century phenomena. By the latter half of the 19th century most of the American labor force was still agrarian and there was no such thing as retirement or pensions. As farm workers became aged, their workload decreased; it was at first shared and then taken over by younger family members. Aged workers continued to be supported by family members until their deaths. As the U.S. economy became less agrarian and more industrial and service oriented in an urban setting, the demographics of the workforce also changed. According to Dora L. Costa, 78 percent of men were still working past the age of 64 in 1880. By 1900 that figure was 65 percent, in 1930 it was 58 percent, and in 1990 it had fallen to less than 20 percent.

The first pension program for the disabled and those of old age in the United States was the Union army pension plan for Civil War veterans and their widows and dependents. This program was considered to be quite generous in that its benefits approximated 30 percent of the wages of a contemporary unskilled laborer—roughly analogous to present-day Social Security benefits. The first private pension plan in the United States was instituted by American Express in 1875; by 1900, 11 more private pension plans were providing retirement benefits. In 1920 the federal government began its pension program and by 1930 nearly 2.7 million workers, approximately 10 percent of the private wage and salary workforce, were covered under pension plans. Once the idea of a pension had gained a foothold in American society it quickly spread, hastened by the Social Security Act of 1935. By the mid-1980s nearly half of the American workforce was covered by pension plans.

The idea that at 65 one is" old" had its beginnings in Germany in 1883 when that age became synonymous with a decline in the ability to labor. In the United States in 1890, Civil War veterans could begin collecting their pensions at age 65 unless they were "unusually vigorous." In 1920 post office letter carriers became eligible for retirement benefits once they reached 65, as did railroad workers in 1933. In 1934 the Commission on Economic Security decided that under Social Security provisions, 65 would be the age to begin receiving Social Security retirement benefits.

By the 1990s the planning and managing of pensions had become a huge industry. In 1993 pension funds could claim $3.4 trillion in assets making private and state and local government pension funds the largest single institutional participants in capital markets. Pension funds control approximately 20 percent of U.S. financial assets by holding approximately 30 percent of all U.S. traded equities and about 25 percent of the value of U.S. corporate bonds, according to R. Glenn Hubbard. There are three reasons why there has been such a rapid growth of managed pension funds as opposed to individual planning and saving. First, pension funds can generally be managed more efficiently and cheaply than individual accounts. Second, life annuities are costly for an individual to participate in and proportionately less costly for institutional investors. Third, there are tax advantages to a managed pension fund. For instance, an employer's matching contribution to a pension plan is generally tax deductible.

As previously mentioned, there are a multitude of pension plans available for U.S. salary and wage earners and a number of options for the self employed. There is not, however, a "laundry list" of plans for all potential retirees. Whether or not a particular plan is available for a specific individual depends on the circumstances of the participant and the employer.

A very popular pension plan is the 401(k). Under this plan employees may choose to have a portion of their pretax wages or salary contributed by the employer to a qualified plan. In 1998 the maximum contribution was $10,000 per annum although this amount is reviewed in terms of inflation every year by the Internal Revenue Service. Employers may also choose to match a percentage of the employees' contribution, usually 25 cents to the dollar, although it may be as little as 10 percent or as great as 100 percent. There are several options for investment including bond and stock mutual funds, money market funds, or company stock. Participant withdrawals from a 401 (k) plan prior to age 59 1/2 are subject to a 10 percent penalty except for death, disability, termination of employment, or qualifying hardship. Withdrawals after the participant has reached 59 + are subject to taxes in the year the funds were withdrawn. The 401(k) plan receives its authorization from the Small Business Job Protection Act of 1996.

The individual retirement account (IRA) is a personal, tax-deferred retirement account which can be set up by an individual. Contributions to an IRA are tax deductible only if the participant or the participant's spouse is not eligible for an employer maintained retirement plan. Individuals who are participating in an employer maintained retirement plan can also open an IRA on their own, but contributions are not tax deductible, with one qualified exception. If the participants are covered by an employer maintained retirement plan, they may deduct contributions to a personal IRA if their adjusted gross income is less than $30,000 ($50,000 for a joint return). Until the IRA participant reaches the age of 70 1/2, annual contributions up to $2,000 ($4,000 for a married couple filing a joint income tax return) are allowed. IRA withdrawals prior to the age of 59 1/2 are usually subject to a 10 percent penalty tax on the principal. IRA withdrawals must begin no later than age 70 1/2, at which time they are subject to being taxed. Partial withdrawals are allowed, but they are based on an IRS schedule related to life expectancy.

A variation on the IRA is the Roth IRA (named after Senator William Roth of Delaware), which was established in 1997. As with a traditional IRA, individuals can invest $2,000 a year in a Roth. Earnings and principal can be withdrawn tax free after the participant has reached 59 1/2 providing the funds have been in the account for five years. Unlike a regular IRA, participants do not have to begin withdrawing funds by age 70 1/2. In fact, funds do not have to be withdrawn at all and may be passed on to beneficiaries tax free. Participants, however, are not allowed a tax deduction for their contributions. Withdrawals up to $10,000 are allowed without penalty if the money is used for the purchase of a first home, college expenses, or disability expenses. There is also an Education IRA that allows parents to contribute $500 per year per child up to the age of 18. Eligibility and contributions are, however, qualified by income.

Self-employed individuals or employees of unincorporated businesses are eligible to establish a Keogh plan, set up and maintained by the participant. Keogh plans are also available for workers who have full time jobs with a pension plan, but freelance on the side. Those eligible for a Keogh plan may contribute 25 percent of earned income up to a maximum of $30,000. Investment earnings are tax deferred until withdrawal, which can begin as early as age 59 1/2 but must start no later than age 70 1/2. Like the 401(k), most any investment plan is acceptable for a Keogh except for collectibles (art, coins, stamps, antiques, etc.) and precious metals. The plan is named after U.S. Representative Eugene J. Keogh and was established by Congress in 1962.

The Pension Benefit Guaranty Corporation (PBGC) is a self-financing, wholly owned government corporation established by Title IV of the Employee Retirement Income Security Act of 1974. The purpose of the PBGC is to protect the pension funds of American workers who participate in a defined benefit pension plan. In 1998 that included nearly 42 million workers in approximately 45,000 different defined benefit pension plans. The PBGC is financed by premiums collected from companies sponsoring insured pension plans, investment returns on PBGC assets, and recoveries from employers responsible for underfunded terminated plans. In 1998 the PBGC was paying monthly retirement benefits to about 260,000 retirees of 2,150 terminated plans. If an insured pension plan terminates without sufficient assets to continue paying benefits, the PBGC will continue the benefits. For single employer plans terminated in 1999, the PBGC guarantees a monthly maximum of $3,051.14.