Financial Tips

Published 12:00 am Wednesday, June 27, 2001

ALAN S. MOORE

Which employee pension plan works for you? Although most employers recognize the need to provide retirement income for employees, the costs and complexity of complying with pension plan law can be prohibitive. However, the available benefits continue to make a pension plan attractive to both employers and employees. There are several types of pension plans, and each has its own characteristics and advantages.

Defined-benefit, Money Purchase and Target Benefit Plans

A defined-benefit pension plan promises its participants a fixed benefit that is generally determined by a formula. An actuary establishes the contributions the employer must make to fund the benefits that have been promised. With a money purchase pension plan, the employer commits to making a specified annual contribution, such as a percentage of each employee’s salary. Instead of a promise of a specific benefit, each employee has a separate plan account to hold the employer’s contributions and any earnings on those contributions. On retirement, the employee receives the balance in his or her pension plan account, rather than a fixed benefit amount. A target benefit pension plan is a blend of the characteristics of defined-benefit and money purchase plans. As with a defined-benefit plan, the employer bases the annual contributions on the amount that is needed to provide a specified benefit at retirement, but unlike a defined-benefit pension plan, there is no guarantee that benefits will be provided. On retirement, the employee receives whatever amount is in his or her retirement plan account, as in the case of a money purchase plan. There are tax advantages to all three of these plan types. The employer can claim a current deduction for plan contributions. Employees are not taxed yearly on the contributions their employer makes for them. In addition, the earnings on the plan’s assets are tax deferred, and the employees’ plan benefits may qualify for favorable tax treatment upon distribution.

Advantages of a Defined-benefit Plan

The pre-determined retirement benefit is the major advantage for employees of a defined-benefit pension plan. The employer bears the risk associated with investing the plan’s assets. The employee has assurance of receiving a certain amount of retirement income regardless of the plan’s investment performance history. When necessary to fund the required benefit, an employer can choose to make defined-benefit plan contributions for older employees that are substantially higher than allowed with other pension plans.

Advantages of a Money Purchase Plan

A money purchase plan shifts the investment risk of the plan’s assets to the employees. Regardless of how the plan’s investments perform over time, the employer has to contribute only the amount that the plan requires. Employers also escape the actuarial requirements and plan termination insurance expenses that a defined-benefit plan requires. A money purchase plan is especially attractive to businesses with many younger employees, who potentially have enough time before retirement to build large balances in their plan accounts.

Advantages of a Target Benefit Plan

The employer’s contributions to a target benefit plan take into account actuarial factors that include an employee’s age and length of service. That allows a larger percentage of compensation for older employees with longer years of service. The employer also avoids having to supplement contributions when investment experience fails to match expectations. Establishing a pension plan means making a long-term commitment to contribute to the plan regardless of fluctuations in the company’s financial performance. That requires a financially secure organization with confidence in its ability to generate the revenue needed to fund the pension contributions. Any pension plan decision should also include a comparison of operating costs. Usually, operating costs are higher for a defined-benefit plan than they are for a target benefit or money purchase plan. It is highly recommended that employers and employees consult with a qualified financial advisor when making any pension plan decisions. ALAN S. MOORE is a Financial Advisor of Legg Mason Wood Walker, Inc., a diversified securities brokerage and financial services firm that is a member of the New York Stock Exchange, Inc.