retirement plans

TWO TYPES OF RETIREMENT PLANS

1. DEFINED BENEFIT (TRADITIONAL PENSION) PLAN: Pays a retiree a specified annual retirement as long as the person lives. The amount of the annual retirement payment will be based on a formula specified by the employer. (These vary from employer to employer, but usually include the number of years worked for the firm, the person’s salary while working, and some %.) A typical formula might be as follows:

RETIREMENT SALARY PAID BY EMLOYER =

(YEARS WITH FIRM) x (HIGHEST SALARY) x (SOME % SET BY EMPLOYER)

2. DEFINED CONTRIBUTION PLAN (Also known as a 401k program after the section of the IRS Code which gives them tax deferred status): Pays some specified amount each pay period into an account over which the employee will have some investment options. In a defined contribution plan, once the employee leaves a firm, that firm has no obligation to provide further funds to the employee.

To calculate the value of a DC plan over time, one needs to set up a small spreadsheet program the looks like the following:

Yr. Employed Salary ER’s Contribution (%Sal.) Yrs. Invested Value at end of Problem

3. VESTING: Whether DB or DC, vesting means that the employee literally owns the retirement or pension benefit. If you are not vested, you do not own anything.

Minimum vesting rules (Pension Reform Act, 2006) are:

For both DB & DC plans, employers may voluntarily vest earlier than these rules if they so choose.