Types of Retirement Plans

If your employer offers a retirement plan, it's likely to be either a defined-benefit or defined-contribution plan. Defined-contribution plans include 401k, 403(b) and 457 plans. All three of these plans are discussed in the previous topic.

Defined-benefit plans are also called traditional pension plans. Defined-benefit plans were once the dominant plan type in the U.S. The Employee Retirement Income Security Act of 1974 (ERISA) expanded the use of defined-contribution plans. (Cash-balance plans are a third type of retirement plan but are not widely used.)

The Pension Benefit Guaranty Corp. (PBGC) is a federal agency that guarantees the traditional (and cash-balance) pension plans of some 44.1 million Americans. The PBGC does not guarantee defined-contribution plans.

Traditional pension plans pay a fixed monthly benefit to retirees for the rest of their lives. When retirees refer to pension income, they are usually referring to monthly income they receive from a defined-benefit plan.

In part, that's because few retirees today rely on defined-contribution retirement plans for their retirement income. As employees in their 50s and 60s today retire over the next couple of decades, pension income is likely to be called something like retirement account income.

How much you receive in monthly benefits from a traditional pension plan is based on your years of service and salary history. You also must work long enough to receive benefits. This process of accruing retirement benefits through years of service is called vesting. (Vesting is also used to describe the time necessary to receive stock options or earn other forms of deferred compensation.)

The definition of service years may vary slightly among plan sponsors. However, the PBGC makes sure that the plan sponsors comply with the vesting rules as defined in ERISA.

The two major types of vesting are cliff and graded vesting. Cliff vesting requires that employees eligible to receive a defined-benefit pension are fully vested after three years of employment service. Graded vesting requires employees eligible to receive a defined-benefit pension to be at least 20% vested after two years of employment service. For each of the successive four years, they must vest an additional 20% so that they are fully vested after six years of employment service.

Monthly benefits for defined-benefit pensions are generally based on one of the following formulas:

Flat-benefit formula. A flat-benefit formula pays a flat monthly amount based on years of service. Flat-benefit formulas are commonly offered to pensioners covered under collective-bargaining agreements.

Career-average formula. A career-average formula pays a benefit amount that is based on your average earnings over the period you are covered by the plan.

Final-pay formula. A final-pay formula pays a benefit amount that is based on your average earnings over your last several years (typically five) of service. Since these tend to be your highest-earning years, benefit amounts are usually greater than if calculated with a career-average formula.

Pension plans sometimes offer options that provide retirement income for a surviving spouse. A joint-and-survivor annuity option provides a surviving spouse a monthly benefit after you die. A pre-retirement survivor annuity option ensures that your spouse receives some or all of your benefit if you should die before you reach retirement age. Check with your plan administrator on the availability of these options.

If you have earned a defined-benefit pension, you may be able to take a lump-sum distribution. The PBGC allows employers to make a lump-sum distribution to retirees if the value of the employee's retirement plan is less than $5,000. With a lump-sum distribution, you can elect to either roll over the money into an IRA or a new employer's retirement plan. Alternatively, you may deposit the lump-sum distribution in a taxable account. Since you may owe income taxes for handling a lump-sum distribution, you may wish to consult your financial or tax adviser.