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What are the Different Types of Pension Plans?

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  • Written By: Gregory Hanson
  • Edited By: Susan Barwick
  • Last Modified Date: 11 September 2016
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All pension plans are designed to provide income and security for workers after they reach the end of their working lives and retire or in the event of a crippling injury. The means used to provide that security vary widely between plans, but two broad categories of pension plans exist, both with merits and flaws. Defined benefit plans provide a set mix of benefits, typically including a cash payment and some additional benefits, often in the form of health coverage. These plans keep paying for the life of a retiree and sometimes his or her spouse, as well. Defined contribution plans rely on contributions from both the employee and the employer to build up a balance, which is then drawn down after retirement.

The key advantage to a defined benefit plan is the fact that it keeps paying benefits, even for very old employees, who might otherwise exhaust their account balances. Defined benefit pension plans also minimize the risks imposed on a system by poor savers, who might underfund their defined contribution plans, and be unable to provide for themselves in retirement. The mix of services and benefits associated with some defined benefit pension plans, which may include such things as discounted travel or museum admittance, especially in European nations, may also serve to keep the elderly more fully integrated into their societies, and thus happier and healthier.

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This type of pension plan has become less popular in recent years, however, due to several potential problems. The greatest problem faced by defined benefit plans is the issue of underfunding. Both corporate and governmental pension plans are often not funded at a level sufficient to keep up with the pressures placed on them by retiree populations, meaning that the plans become less and less solvent over time and may eventually fail. Corporations and occasionally governmental entities also sometimes default on these plans, leaving retirees with no pension whatsoever. Inflation can also be a problem with this variety of plan, as a high rate of inflation rapidly erodes the real purchasing power of a defined benefit.

Defined contribution plans have a different set of advantages. Since the money in these plans is administered by the workers themselves, they are not vulnerable to underfunding by employers. These plans are also portable, which is an advantage in a world where few workers spend an entire career with a single employer.

There are problems associated with defined contribution plans as well, however. If workers choose not to pay into such a plan, and payments are often voluntary, then they will have no retirement funds when they finish their working lives. The distributed nature of defined benefit plans means that they require a greater degree of administrative overhead, as well, which means more money spent on fees to fund managers and brokers and less money for retirees.

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