How Pension Funds Work

Pension funds can help support retirees.

Pension funds can help support retirees.

Pension funds are an important part of many retirement plans. There are two main types of pensions: defined benefit and defined contribution. In both cases, the employer operates the plan with the help of financial consultants. Pension funds are designed to collect enough money to pay for current and future pensioners who will draw income from the fund.

Defined Benefit Plans

A defined benefit plan has a fixed level of benefits that it awards to retirees of the organization running the plan. These benefits might take the form of a percentage of the worker's final salary, for example, and might have conditions requiring a certain number of years worked to allow access to full benefits. Defined benefit plans might also simply guarantee some level of retirement income regardless of final salary.

Defined Contribution Plans

Under a defined contribution plan, the employee and employer decide on a percentage of the employee's salary that will be contributed to a general pension fund in the employee's name. The employer might also match the contribution up to a limit. For example, if the employee contributes 6 percent of her annual income, and the employer matching limit is 3 percent, the employer will add money equal to 3 percent of the employee's annual salary out of his own pocket. The final result is that the worker will receive 94 percent of her salary in cash. Each year, the combined employee-employer contribution to her pension will equal 9 percent of her salary. The contributions grow through investment. Upon retirement, the employee is entitled to the money contributed as well as any additional money gained from the investment.

Pensions as Investors

Especially under defined contribution plans, pension funds need to grow to meet the needs of current and future retirees. As a result, pension funds use their contributions to make investments in equities and fixed-income financial products. A professional asset manager usually controls the fund. Investment allows pension funds to grow, but also exposes them to the risk of loss. Investing in equities can be a high-growth, high-risk prospect, so pension funds also invest in fixed income securities like Treasury bonds to have some slower but safer growth at the same time. Pension funds can be the largest investors in the world due to how much money they control at once.

Implications of Pensions

The value of a pension fund can fluctuate from year to year based on the performance of the fund's investments. However, this is less relevant for younger workers, who won't be drawing money from the fund for a long time. There are tax penalties for withdrawing from a pension fund before the age of 59 1/2. Depending on the specifics of the plan, taxes may be due either on contributions or on withdrawals.

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