Pension

A pension is a means to provide a person with a secure income for life. A lottery may provide a pension but the common use of the term is to describe the payments a person receives upon retirement.

Pensions have traditionally been payments made in the form of a guaranteed annuity to a retired or disabled employee, or to a deceased employee's spouse, children, or other beneficiary. A pension created by an employer for the benefit of an employee is commonly referred to as an occupational or employer pension scheme. Labour unions, the government, or other organisations may also sponsor pension provision.

Types of pension scheme

A pension scheme that provides a guaranteed benefit is commonly called a defined benefit pension scheme. A defined benefit scheme typically employs a formula based on the employee's pay, years of employment and age at retirement to calculate the guaranteed payment. The United States Social Security system is an example of a defined benefit pension arrangement.

Defined benefit schemes used to dominate pension provision in both the private and public sector. However, a guaranteed, or "defined" benefit is no longer the universal pension payment model. Instead, the benefit may be based solely on the value of the accumulated assets in a pension fund at the time payment is to begin.

A pension scheme of this kind is commonly called a defined contribution plan. In a defined contribution pension scheme, the employer, the employee or both make contributions into an individual investment fund. This fund is invested in underlying investments, such company shares, and will move in line with the return on these investments. At retirement, and occasionally in other circumstances, the individual draws income from the fund. This is often done by purchasing an annuity, which provides a secure income for life, from an insurance company.

In a defined contribution plan, investment risk and investment rewards are assumed by each individual/employee/retiree and not by the sponsor/employer. In the United States, the most common example of a defined contribution employer pension scheme is the 401(k) profit sharing plan.

Financing

There are various ways in which a pension scheme may be financed. In a funded scheme, contributions are paid into a fund during an individuals working life. The fund will be invested in assets, such as stocks, bonds and property, and grow in line with the return on these assets.

In an unfunded scheme no assets are set aside and the benefits are paid for by the employer or other scheme sponsor as and when they are paid. Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly from current workers contributions and taxes. This method of financing is known as Pay-as-you-go. It has been suggested that this model bears disturbing resemblances to Ponzi schemes

In a funded defined benefit arrangement, if the employee's contributions and accumulated earnings are not sufficient to pay the guaranteed, or "defined" benefit, the sponsor must cover the shortfall with additional contributions. Sponsors employ actuaries to calculate the contributions that need to be made to ensure that the pension fund will meet future payment obligations. This means that in a defined benefit pension, investment risk and investment rewards are typically assumed by the sponsor/employer and not by the individual.

Political and economic issues

In many countries, the average age of the population is increasing. This can put pressure on pension schemes. For example, where benefits are funded on a pay-as-you-go basis, the benefits paid to those receiving a pension come directly from the contributions of those of working age. If the proportion of pensioners to working age people rises, the contributions needed from working people will also rise proportionately.

In order to reduce the burden on such schemes, many governments give private funded pensions a tax advantaged status in order to encourage more people to contribute to such arrangements. Governments often exclude pension contributions from an employee's taxable income, while allowing employers to receive tax deductions for contributions to pension funds. Investment earnings in pension funds are almost universally excluded from income tax while accumulating prior to payment. Payments to retirees and their beneficiaries also sometimes receive favorable tax treatment. In return for a pension scheme's tax advantaged status, governments typically enact restrictions to discourage access to a pension fund's assets before retirement.

The personal pension scheme has also emerged in recent decades. In a personal pension scheme, an individual saves, usually on a tax advantaged basis, for income at retirement. In the United States, an example of a personal pension scheme is the individual retirement arrangement" (IRA). (IRA alternately stands for "individual retirement account" or "individual retirement annuity.") Personal pension schemes are typically defined contribution because there is no sponsor to guarantee future benefit amounts, so the individual has to assume the risk of future investment returns being less than expected.