A) U.S. Pension System
Three kind of Pensions
- Old Age Pension
- Next of Kin Pension
- Disability Pension/Insurance
Pensions are funded by three pillars
- Pillar 1: Governmental pensions for qualifying citizens
- Pillar 2: Corporate pensions for employees
- Pillar 3: Private insurances, investment plans, real estate and savings
In the U.S. the average person receives pensions for 20 years. Most funding is provided by corporate pensions, then by private means and last by governmental pensions.
B) U.S. Governmental Pensions
Federal Social Security Benefits are for most Americans a relevant part of their pension benefits.
The height of their claim depends on:
- the height of their lifetime earnings and paid taxes
- the age at which they'll begin receiving benefits
- if they'll be eligible to receive a spouse’s benefit instead of their own
The governmental old age pension can start as of age 62 and the latest at age 70.
The later it starts, the higher the benefit.
B] Working Abroad
If a U.S. citizen does not have enough credits from his work in the U.S. to qualify for pension benefits, he may be able to count his work credits from another country. The Social Security Administration has agreements with 26 countries which can be taken into account.
C] Payment Abroad
U.S. citizens can live in most foreign countries and still receive their Social Security benefits. To inquire if you can receive benefits in the country you’ll be living in, you can use the Social Security Administration’s Payment Verification Tool.
As of now we will focus solely on U.S. Corporate Pensions.
C) U.S. Corporate Pension Plan in General
It is a formal corporate employee benefit plan created or maintained by
- an employer or
- an employee organization (union) or
and provides retirement income or defers income until termination of covered employment or beyond.
B] Not Mandatory
U.S. legislation does not oblige each private employer to have his employees participate in a corporate pension plan.
C] Access To Guaranteed Pension Plan
As participation is not mandatory by law, it is possible for an employee not to participate in a corporate pension plan and especially not to have access to a guaranteed pension annuity as of retirement age:
- 82% of union members versus 21% non union employees have access to a guaranteed pension.
- For comparison: most public servants have access to a guaranteed pension.
- The smaller the company, the smaller the access to a guaranteed pension.
- The sector matters: In Utilities most employees have access to a guaranteed pension, in Insurance Carriers 50% and in Food Services 3%.
- In most guaranteed pension plans the employee only qualifies for complete claims when he has worked at the company for at least 5 years: job hopping decreases pension claims.
- If you work part-time you will be often excluded from access to a guaranteed pension plan.
- Guaranteed company pensions are most common in the Middle Atlantic (26 %) and the Northeast (25 %) and least likely in the South.
D) U.S. Corporate Pension Plan: ERISA
A] Employee Retirement Income Security Act (ERISA)
ERISA is a collection of federal statutes that take precedence over most state pension laws.
It sets minimum standards for most voluntarily established pension plans in private industry. It provides protection for participants.
B] ERISA Requires Plans To
- provide participants with information about plan features and funding.
- create responsibilities for those who manage and control plan assets.
- restrict the kind of investments that trustees can make using pension funds.
- mandate that the employer makes annual contributions to the pension fund.
- devise formulas for setting minimum contribution levels.
- establish a grievance and appeals process for participants to get benefits from their plans.
- give participants the right to sue for benefits and breaches of fiduciary duty.
C] ERISA Does Not Cover
- pension plans by governmental entities, churches or plans solely to comply with workers compensation, unemployment or disability laws.
- pension plans with 25 or less participants.
- pension plans solely for business partners or a sole proprietor.
- plans maintained outside the U.S. primarily for the benefit of nonresidents or unfunded excess benefit plans.
Employees of businesses not covered by ERISA may look at state statutes governing pensions that contain regulations and requirements.
D] Vesting Of Pensions
ERISA gives employers using a pension plan that is not funded by the employees several methods for the vesting of pensions:
- the employer may allow all pension benefits to become nonforfeitable once the employee has completed five years of employment or
- an employee may be guaranteed a percentage of pension funds according to length of service, with the percentage increasing as the length of service increases:
- after three years of service the employee is guaranteed 20 % of the derived benefit from the employer contributions to the pension plan.
- after four years the employee has a right to 40 % of the benefits.
- after five years the percentage is 60%.
- after six years the percentage is 80%.
- an employee who completes seven years of service becomes fully vested.
An employee is always entitled to the amount of money he has contributed to a pension fund.
E) U.S. Corporate Pension Plan: PBGC
A] Pension Benefit Guaranty Corporation (PBGC)
It provides federal insurance for certain private single/multi employer pensions.
Currently it covers 40 million Americans and is responsible for the benefits of about 1.5 million Americans in failed pension plans:
- It covers most guaranteed private sector pensions.
- It covers most cash-balance plans which provide guaranteed pensions which allow a lump-sum distribution.
- It does not cover governmental pensions, 401(k) plans, IRA’s and certain similar plans.
C] Maximum Individual Coverage
If your plan is insured and it ends without enough money to pay all benefits, PBGC will pay you the money you’re owed, up to legal limits. The 2017 maximum monthly guarantee for a 65-year-old retiree of a single employer plan is $ 5.369,32 which amounts to about $ 64.432 per year. The guarantee limit for multi-employer plans is very different and substantially lower.
The single/multi-employer program differ also significantly in the insurable event that triggers the guarantee and premiums paid by insured plans. By law, the two programs are financially separate and each has a substantial deficit.
PBGC may not fully guarantee your benefits if your plan was created or amended to increase benefits within five years before its termination date.
To check if your pension is insured, search PBGC's list of single-employer and multi-employer plans.
F) U.S. Corporate Pension Plan: DC/DB/Hybrid
A] Defined Contribution Plan (DC)
In a Defined Contribution plan, the employer deposits a certain amount of money based on the employee's wages in the employee's name into the pension plan. The employer makes no promises about the level of pension benefits upon retirement.
Besides employer contributions money can be contributed from employee wages deferrals or by employer matching contributions.
The employee has the total investment and interest rate risk. The employee also has the risk of investment failure as these funds are not insured by PBGC.
Upon retirement, the participant's account is used to provide retirement benefits, often through the purchase of an annuity.
Examples of DC plans include 401(k) and 403(b) plans, employee stock ownership plans and profit-sharing plans.
B] Defined Benefit Plan (DB)
In a Defined Benefit plan, the employer gives a guaranteed amount of pension claim based on the employee’s wages and length of employment. Thus the employee has no investment nor interest rate risk. Employees assume further little risk as most funds are insured by PBGC to a certain limit.
The pension is paid as an annuity but other kinds of distribution like Lump Sum may be available but are not required.
The employee has no separate account as the premium is administered through a trust established by the employer. A DB plan is required to maintain adequate funding if it is to remain qualified.
Due to the historically low interest rate DB pension claims have become very expensive and less popular among employers.
C] Hybrid Plan
In a Hybrid plan there are aspects of DB and DC nature.
D] Cash Balance Plan
A good example of a hybrid plan is the Cash Balance Plan: It is a DB plan that defines the benefit in terms that are more characteristic of a DC plan as it defines them in terms of a stated account balance.
In a typical cash balance plan, a participant's account is credited each year with a ‘pay credit’ ( x % from the employer) and an ‘interest credit’ (a fixed or variable rate that is linked to an index). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer. An aspect that makes these plans clearly no DC plans.
The benefits in most cash balance plans are, like those from typical DB plans, within limits protected by the federal PBGC.
The cash balance plan typically offers a Lump Sum at and often before standard retirement age. However, equally to DB plans, a cash balance plan must also provide the option of receiving the benefit as a lifelong annuity. Which amount must be ‘definitely determinable’.
G) U.S. Corporate Pension Plan: Annuity/Lump Sum Pay-Out
In case of a guaranteed DB pension plan, plans often give the option to receive the annuity as of retirement age or a Lump Sum before or at retirement age.
A Lump Sum means that the total pension entitlement is received in one capital at once as a buy out. A pension annuity means that as of retirement age the participant will receive a periodic and lifetime constant pension term.
A] Lump Sum Option
Many participants opt for the Lump Sum. If your health is not that good or if you are single, a Lump Sum might make sense. Also if the financial health of the pension plan is not that good and if the insurance coverage by the PBGC would not be sufficient.
In case of Lump Sum, you might put the capital into a traditional IRA. Otherwise, you’ll get a big tax bill. Smaller withdrawals from the IRA will likely be taxed at a lower rate.
B] Annuity Option
But if you and your partner are in good health the annuity might be the better choice as you will benefit from the participants who pass away. Participants who don’t live as long subsidize those who live longer. Which makes the annuity especially attractive for women as they tend to live longer.
C] Partial Annuity/Lump Sum
Finally you might want to split your pension in part annuity and part Lump Sum. Thus you're better able to fine-tune your overall mix of guaranteed income and investable assets and avoid ending up with too little, or too much, of either one.
Unfortunately most companies that have a Lump Sum option offer only an either-or choice.
H) U.S. Corporate Pension Plan: Taxation
A] Qualified Plans
Qualified plans receive favorable tax treatment. If a plan does not any longer meet the applicable demands, the plan might be disqualified and face huge tax consequences.
Regarding DB plans, the IRS has specific requirements for them to be qualified:
- A plan has to offer certain life annuities.
- A plan has to maintain sufficient funding levels.
- A plan has to be administered according to the plan document.
- Benefits are required to start at retirement age.
- Once earned, benefits may not be forfeited.
- A plan must be insured by the PBGC.
- A plan may not discriminate in favor of highly compensated employees.
B] Non-Qualified Plans
Non-qualified plans do not meet the IRS demands and do not receive favorable tax treatment. They are often used to give extra benefits to executives.
C] In General
In general pension premium paid by an employer into a pension plan will within limits not be taxed as income untill retirement age and then so at a probably lower tax bracket in case of annuity pay-out. The wages that the employer withholds during the working life of the employee is equally not taxed until retirement age.
D] Excise Tax
In nearly every type of qualified pension plan, withdrawals made before the age of 59,5 are subject to a 10% IRS tax penalty called Excise Tax in addition to the standard income tax.
E] Maximum Contribution
Defined contribution plans are subject to Internal Revenue Code limits on how much can be annually contributed. Currently the maximum contribution for the employee amounts i.e. to $18.500,- and to $ 24.500,- as of age 50.
GOP lawmakers are thinking about reducing these amounts to maximum $ 2.400,-. Even though it did not happen in the spring of 2018, it might again be put on the GOP agenda.
F] IRS Regime
To prevent tax abuse, the IRS has rules that require pension plans to be permanent as opposed to a temporary arrangement in order to receive tax benefits.
An employee may reserve the right to change or terminate his plan. But to end the plan for any reason other than business necessity within a few years after it has taken effect, will be evidence that the plan from its inception was not bona fide.
It would give the IRS grounds to disqualify the plan retroactively, even if the plan sponsor initially got a favorable determination letter.
I) U.S. Corporate Pension Plan: Auto Enrollment Plan
A] Coverage Without Employee Action/Consent
It means that an employer has decided to sign employees up to have a percentage of their paychecks automatically placed into a retirement account. It does not require the employee to take action or even to consent. The employer decides what percentage of the employee’s paycheck will automatically be placed in the account.
B] Increased Participation
These plans increase the number of employees who save for retirement. It is usually for employees to save for retirement. While many employers have retirement plans, these plans usually require the employee to opt in. Many employees don’t take this step. Thus they miss out on employer matching contributions when offered and don’t set aside enough for retirement.
The employer who starts with auto enrollment needs to choose a default investment for employees’ retirement plan contributions. He can limit his fiduciary liability by choosing lifecycle or balanced funds. They help employees to have an optimal return on investment versus risk ratio.
Even with auto enrollment, employees can still choose how their money is invested within the options of the plan. They can also change the amount of annual investment and can even decide to opt out.
J) U.S. Corporate Pension Plan: Small Business Pension Plan
A] Wide Variety
Small business owners can set up a wide variety of pension plans at any bank, mutual fund, insurance company or brokerage firm. The fees vary depending on the plan's complexity and the number of participants.
B] Qualified Plan
A small business owner who wants to establish a qualified plan for himself must also include all other company employees who meet minimum participation standards. He must include all non owner employees in any company sponsored pension plans and make equivalent contributions to their accounts! The latter reduces his net earnings and therefore his own maximum contribution to a qualified pension plan.
C] Non-Qualified Plan (NDCP)
Which makes some of these small business owners to supplement their own retirement funds through a personal non qualified savings plan.
A non-qualified deferred compensation plan (NDCP) is a contractual agreement in which a participant agrees to be paid in a future year for services rendered this year. It defers taxation to a year when the recipient might be in a lower tax bracket. Deferred compensation payments generally start upon termination of employment.
D] There Are Two Kind Of NDCP’s
1) Elective NDCP: an employee or business owner chooses to receive less current salary and bonus compensation than he would otherwise receive postponing the receipt of that compensation until a future tax year. It is also called a ‘Deferred Savings Plan’.
2) Non-elective NDCP: the employer funds the benefit and does not reduce current compensation in order to fund future payments. Such plans are i.e. post-termination salary continuation plans. It is also called a ‘Supplemental Executive Retirement Plan’ (SERP).
NDCP’s are not limited by the same non-discrimination rules imposed on qualified plans. They may be offered to a select group of employees only. Which makes the cost of this benefit lower since it accrues to fewer people.
Furthermore administrative costs are lower with NDCP’s than for similar qualified plans.
K) U.S. Corporate Pension Plan: Different Types
Besides the regular collective corporate pension plan, there are the following possibilities:
A] IRA: Individual Retirement Account
It is a personal retirement account that workers may establish in addition to, or instead of, an average pension.
A traditional IRA is a way to save for retirement that gives you tax advantages. Contributions may be partially/fully deductible, depending on your circumstances. Generally, amounts in your traditional IRA are not taxed until distributed.
The total annual contributions to all of your personel traditional and Roth IRAs cannot be more than
- $5.500,- or $6.500,- if you’re age 50 or older
- or if less your taxable compensation for the year.
You can make your IRA contribution for 2018 as a Lump Sum or periodic.
The owner controls his IRA. It has a DC nature and the owner determines the investment policy. Some kind of investments though are not allowed.
You can set up an IRA with a bank, life insurance company, mutual fund or stockbroker.
B] Simple IRA: For Small Employers
It is an IRA that is provided by small employers with less than 100 employees. It is similar to a 401(k) plan but offers simpler and less costly administration rules. Like the 401(k) plan, it is funded by a pre-tax wages reduction.
C] Roth IRA: Tax Upfront Really Attractive?
While the traditional IRA has a (very relevant) ‘tax deferred’ nature, the Roth IRA has a ‘after-tax’ nature. The contributions are not tax deductible and qualified withdrawals do not count toward the taxable income. In other words, they are 100% tax-free.
Roth contributions may be withdrawn penalty-free at anytime. There is no required minimum distribution rule like with other retirement accounts. The downside is that the ability to contribute directly to a Roth IRA is subject to the mentioned limitations.
D] Keogh Plan: For The Self-Employed
It is a type of retirement plan reserved for those that are self-employed or part of an unincorporated business. It allows you to save on a tax-deferred basis. You can set up your Keogh plan to be a defined contribution or defined benefit pension plan.
E] 401(K): Most Popular DC Plan
A 401(k) plan is defined in subsection 401(k) of the Internal Revenue Code.
It is a traditional retirement plan that is normally offered by all corporations. It is the most popular defined contribution plan that is a cash or deferred arrangement. Many companies use their 401(k) plans as a means of distributing company stock to employees. Few other plans can match the relative flexibility that 401(k)’s offer.
401(k) plans are a type of retirement plan known as a qualified plan. This means that this plan is governed by the regulations stipulated in the Employee Retirement Income Security Act of 1974 and the tax code. Employees can choose to defer receiving a portion of their wages which is instead contributed on their behalf, before taxes, to their 401(k).
Sometimes the employer may match these contributions. There is a limit on the amount an employee may elect to defer each year. The maximum annual contribution for 401(k) accounts in 2018 amounts to $18.500,- and for employees as of age 50 to $24.500,-. Matching contributions from employers are not counted in this maximum. However, there is a total limit for all contributions from all sources. The new maximum contribution from all sources will be $55.000,- for workers under age 50 and $61.000,- for workers as of age 50.
Choice for Employee
The 401(k) does not require any employee contribution. So each employee is responsible for his own financial future.
An employer must advise employees of any limits that may apply. Employees who participate in 401(k) plans assume responsibility for their retirement income by contributing part of their wages and often by directing their own investments. Plan contributions are invested in a portfolio of often mutual funds, but can include stocks, bonds and other investment vehicles if permitted under the provisions of the plan.
Most 401(k) plans provide retiring employees with several pay-out options. Lump Sum payments, instalment payments for a fixed number of months and annuities are available distribution methods. It is also possible to defer any payment until a certain age. Required minimum distributions (RMD’s) must begin at age 70,5 unless the participant is still employed and the plan allows RMD’s to be deferred until retirement.
The distribution rules for 401(k) plans differ from those that apply to IRA’s. The money inside the plan grows tax-deferred as with IRA’s. But while IRA distributions can be made at any time, a triggering event must be satisfied in order for distributions to occur from a 401(k) plan.
As a result, 401(k) assets can usually be withdrawn only under the following conditions:
- Upon the employee's retirement, death, disability or separation from service with the employer.
- Upon the employee's attainment of age 59,5.
- When the employee experiences a hardship as defined under the plan, if the plan permits such withdrawals.
- Upon the termination of the plan.
Automatic Enrollment Option
A special kind of 401(k) plan is the version which automatically enrolls employees of a company. Thus employees of a company with this policy are enrolled in the plan at a default contribution rate. Often around 2,5% of the wages. The funds are directed into a standard default allocation. Employees can change the terms of the plan or opt out completely if they prefer not to participate. This differs from the standard 401(k) in that retirement savings will continue to accumulate without any action from the employee. Therefore this version is also known as an ‘automatic 401(k)’.
Finally the 401(k) ‘Plan Fees Disclosure Tool’ provides employers with a way to get uniform information on fees from prospective plan service providers and to be able to compare them on the correct and equal bases.
F] Roth 401(K): Tax Upfront Really Attractive?
They were first introduced in 2006 and now 58% of the employers offer them. It combines many of the benefits of the Roth IRA and the traditional 401(k) plan. There is the same maximum contribution as a traditional 401(k) while still having the tax now/no tax in retirement benefits of a Roth IRA.
Traditional 401(k) contributions and earnings are taxed when you start receiving as of age 59,5 in retirement. A Roth 401(k) however is taxed up front. All of your contributions and earnings are tax free once you reach age 59,5.
Withdraw Without Sanction
You can withdraw Roth contributions tax and penalty free if your account has been open for at least 5 years. This does not include earnings on contributions. With a Traditional 401(k), you cannot withdraw without a 10% penalty.
Roth 401(k)’s can be rolled tax free into a Roth IRA when you leave your employer. Similarly, traditional 401(k)’s can be rolled into a traditional IRA tax free. If you try to roll a traditional 401(k) into a Roth IRA, you must pay income tax on your rollover during the year it is completed. So once your money is in a Roth 401(k), it cannot be transferred to a traditional 401(k) or a traditional IRA. It can only be rolled over to a Roth IRA at the time of departure from your employer.
For Younger Employees?
A Roth 401(k) is designed to be advantageous to a younger employee who may be in a lower tax bracket at their young age than in retirement. But is it wise to directly pay taxes instead of generating decades of compounded return on investment on money that would otherwise go to the IRS?
G] 401(A): For Governmental Institutions
What is the difference between a 401(k) and 401(a) plan?
- 401(k) plans are offered by Corporations and 401(a) plans by Government Institutions.
- While a 401(k) plan allows for the Employee to decide how much he prefers to contribute, contribution levels of a 401(a) plan are set by the Employer.
- A 401(k) plan offers the Employee a range of investment options, while a 401(a) plan gives more investment control to the Employer.
- While a 401(k) plan is not mandatory, a 401(a) plan might be mandatory.
H] 403(B): For Certain Public Focused Institutions
It is a tax advantaged pension plan available for public education organizations, some non-profit employers, cooperative hospital service organizations and self-employed ministers in U.S.
The tax position is similar to a 401(k) plan. Employee wages deferrals into the plan are made pre-tax and allowed to grow tax-deferred until the capital is taxed as income at the pay-out.
I] 457(B): For Government Worker
It is an employer-sponsored, tax-favored retirement savings account. It is offered to state and local government employees. It is like the ‘401(k) for the government-worker’.