A funded retirement plan, often referred to as a funded pension plan, is a type of retirement plan where the necessary funds are set aside in advance and invested to generate sufficient returns for the payment of future retirement benefits to employees. These plans are generally established by employers, governments, or other organizations and can be either defined benefit plans or defined contribution plans.
Mechanism and Structure
Funded vs. Unfunded Retirement Plans
- Funded Retirement Plan: The employer contributes to a fund that is specifically set aside to meet the future pension obligations. These funds are invested in various assets such as stocks, bonds, and real estate, with the returns used to pay out retirement benefits.
- Unfunded Retirement Plan: These are pay-as-you-go schemes where current workers’ contributions are used to pay current retirees. There is no separate pool of assets set aside, thereby posing higher risks in terms of future solvency.
Investment and Management
A funded retirement plan involves the careful management of the pension fund. Financial professionals typically manage these funds, diversifying investments to balance risk and return, ensuring future liabilities can be met.
- Asset Allocation: This involves distributing investments among different asset categories like equity, fixed income, and alternative investments to optimize returns and manage risk.
- Actuarial Valuation: Periodic assessments performed by actuaries to estimate the future liabilities and ensure the fund’s assets align with future benefit obligations.
Historical Context
Funded pension plans have evolved through centuries. Early pension schemes can be traced back to Roman times and medieval guilds, but the modern concept of funded retirement plans gained traction during the late 19th and early 20th centuries with the advent of industrialization and longer life expectancies. Landmark legislations, like the Employee Retirement Income Security Act (ERISA) in 1974 in the United States, formalized the regulation of these plans.
Types of Funded Retirement Plans
Defined Benefit Plans
In defined benefit plans, the employer promises a specific retirement benefit amount based on a formula considering factors like salary history and duration of employment. The employer bears the investment risk.
Defined Contribution Plans
In these plans, the employer, employee, or both make contributions to the individual’s retirement account. The future benefits depend on the investment’s performance. An example is the 401(k) plan in the United States.
Special Considerations
Regulatory Compliance
Funded pension plans are subject to stringent regulatory scrutiny to protect beneficiaries. Compliance with standards such as those mandated by the ERISA in the U.S. is pivotal.
Funding Status and Solvency
Evaluating the funding status, measured by the ratio of assets to liabilities, is crucial for assessing the financial health of a pension plan. A solvent plan has sufficient assets to cover its future liabilities.
Examples of Funded Retirement Plans
- Private Sector Funded Plans: Companies like IBM and General Electric historically offered robust defined benefit pension schemes.
- Public Sector Funded Plans: Government employee pension schemes, such as the California Public Employees’ Retirement System (CalPERS).
Applicability and Implications
For Employers
A funded retirement plan can be an effective tool for attracting and retaining employees. However, it requires significant financial commitment and proficient management to ensure long-term sustainability.
For Employees
Such plans provide financial security in retirement, with defined benefit plans offering predictable income, while defined contribution plans allow personal investment control.
Related Terms
- Actuary: A professional who assesses financial risks using mathematics, statistics, and financial theory.
- Pension Fund: A common pool of assets forming an independent legal entity that provides benefits to retirees.
- Vesting: The process by which an employee gains non-forfeitable rights to employer-contributed pension benefits.
FAQs
What is the main difference between a funded and unfunded retirement plan?
How are funded retirement plans regulated?
Are contributions to funded retirement plans tax-deductible?
References
- Employee Retirement Income Security Act (ERISA), 1974.
- “Pension Planning: Pension, Profit-Sharing, and Other Deferred Compensation Plans,” Everett T. Allen and Joseph J. Melone.
- The Pension Answer Book, Stephen J. Krass.
Summary
Funded retirement plans are essential mechanisms for ensuring financial stability for retirees. By setting aside and investing funds, these plans provide a structured and secure approach to meet future retirement obligations. With careful management and regulatory compliance, they play a critical role in the financial planning of both employers and employees.
