What is a pension plan? – A Detailed Guide
As retirement approaches, ensuring financial stability through a pension plan becomes a top priority for most individuals. Therefore, as an employer or employee, the need to secure your future or provide valuable benefits to your workforce makes understanding this subject necessary.
So, in this article, we will explore the types and benefits they offer. Read on to be well-informed.
What is a pension plan?
A pension plan is an aspect of a retirement plan that promises to pay a defined benefit for an employee’s life after retirement. It is usually paid out as a percentage of your salary throughout your working periods, and the percentage is determined mostly by your employer.
However, in some organizations, like the federal government tenure, you will likely get a higher percentage based on how long you’ve worked for them. For example, an employee with a government tenure may get 80% of their salary, and one with less tenure gets 50% or less.
If you stop working before your pension benefits vest, your long-arranged retirement money will be automatically forfeited. However, with graded vesting, a certain percentage of your yearly benefit vest is rewarded till you reach 100% vesting. With cliff vesting, you have no claim to any of the company’s contributions till a certain period.
Two main types of Pension plan
Among various types of pension plans, the majority of pension plans fall into the Defined contribution (DC) and Defined benefits (DB) categories. Let’s examine the differences.
Defined Benefit(DB)
Defined benefits are schemes where your accrued benefits are based on your earnings and the length of service or membership in the scheme. This scheme undoubtedly offers valuable benefits to those who use it. The key benefits are as follows:
A guaranteed income for life usually comes with a tax-free cash lump sum. The scheme determines the age at which you take the benefits, typically between 60 and 65.
Unlike other pension plans, where the employee makes at least a 5% contribution of their salary, you don’t need to contribute as an employee. Your contributions are rather managed by your employer, which leaves you with more money when you receive your salary.
Also Read: Simplified Employee Pension Plan
It provides financial security for a family member or next of kin upon your dismissal and continues to pay your beneficiary a percentage of your retirement income. It could also payout a tax-free lump sum calculated as multiple averages of your final salary upon your passing before 75.
The possible downsides of defined benefit are:
Lack of flexibility in your monthly pension: You could receive less pay based on your pension fixed amount, unlike a contribution pension, which allows you to choose an amount to withdraw each month or take out a lump sum.
You may receive less if your employer encounters financial challenges. You also have a minimum choice when appointing a beneficiary.
Defined contribution pension (DC)
In a defined contribution pension, you or your employer set up this scheme to deposit a predetermined amount into your pension plan. Your deposits are usually managed by a company that invests the funds, hoping they will grow over time and prepare them for retirement.
Meanwhile, your payment will be based on the amount deposited, the investment performance, and the charges applied. The value you get after investment could also increase or decrease, depending on market experience. So, you must keep in mind that the levels and reliefs of taxation could change at any time, depending on individual circumstances.
Workplace pension
This scheme, mostly known as a company or workplace pension, is offered automatically through your employer once you become a staff member. However, you may decide to opt-out at any time.
You may as well benefit more when your employer pays into your pension alongside your contributions and might even deposit a higher amount when you contribute more.
Furthermore, the workplace pension works exactly like a personal pension, where you have full access to when and how to withdraw your savings from the age of 55 or 57.
Self-invested personal pension (SIPP)
A self-invested personal pension is a type of contribution pension that offers you a wide range of investment choices. The scheme usually offers hundreds of funds investment opportunities and the ability to hold individual shares, stocks, and assets.
Nevertheless, the scheme is unsuitable for everyone except those who are investment-oriented or experienced in actively managing their investments. The taxation in this scheme depends on individual circumstances, and the value could either fall or rise at any time.
Self-employed pension
This pension plan is an individual arrangement to increase your financial security upon retirement. As self-employed, you cannot join occupational pension schemes, although you may receive the state pension that is subject to a sufficient national insurance record.
Conclusion
In conclusion, a pension plan plays an essential role in securing your financial stability and peace of mind during retirement. The steady income stream will help you maintain a steady standard of living after you’ve stopped working. Therefore, it’s important to consider a pension plan as you plan for the future. The list provided above will help you make an informed decision on your preferred pension plan.
