Pension Plan Basics

Finding and keeping good employees is a difficult prospect for any business. Yet even small firms can compete in the job market if they know how to use the right benefits to beef up their compensation packages. One way to do this is to offer your employees pension plans.

Types of Plans

• Defined benefit plans. In this type of plan, an employer pays a retired employee a fixed amount, based on a formula that includes such factors as an employee's age, earnings, and years of service. Most employers fund their plans by placing money in dedicated investment funds under the control of professional money managers.
• Defined contribution plans. In this plan, employees contribute to their own pension accounts and assume a share of the investment risk. In some cases, the employer also contributes to the plan, usually by matching the employee's contribution. Some of the most popular retirement plans, including 401(k) plans, fall into this category.

Pension Plan Guarantees
Defined benefit plans provide a safety net: if an employer is no longer able to fund its pension plan, the federal Pension Benefit Guaranty Corporation (PBGC) can step in and take over the plan. The PBGC collects insurance premiums from employers who offer defined benefit plans; in return, the government guarantees that pension recipients will continue to receive their benefits.

Defined contribution plans do not enjoy similar guarantees. The return on this type of plan depends largely on how much employees (and employers) contribute to their plans, and how they decide to invest their funds.

Tax Advantages
Qualified pension plans meet complex legal guidelines established in the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code. As a result, qualified plans offer several key benefits: growth inside a qualified plan is not taxable until it is distributed; employer contributions are tax-deductible; and employee contributions are also not taxable until they are distributed.

Nonqualified plans don't meet ERISA guidelines and the requirements of the Internal Revenue Code, and they don't get the same tax breaks. These plans are usually designed to provide deferred compensation for executives and high-level employees, and are not as well-suited for basic employee retirement plans.

Discontinuing Pension Plans
Occasionally, an employer will terminate a pension plan, either voluntarily or due to factors beyond its control. There are two ways to proceed with a termination:

• Standard termination. An employer can terminate a fully funded plan if it demonstrates that it has enough money to pay all its future benefits. The plan then provides benefits by purchasing an annuity — which is usually distributed periodically over an employee's lifetime — or through a lump-sum payment.
• Distress termination. Under certain conditions (such as bankruptcy), an employer can terminate a plan even if it lacks the money to pay what it owes. To complete a distress termination, an employer must show that it is financially unable to support the plan. The PBGC then steps in and ensures that current and future retirees receive their benefits.

Before setting up or terminating a pension plan of any type, you should consult the advice of an attorney, accountant, and financial expert. Read Terminating Your Company Retirement Plan for more guidance on how to handle the different types of plans.

For ideas about other ways to boost your compensation package, read Key Compensation Components.