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Pension Plans for Americans

10 January, 2011 12:23  Erin Erin

Pensions US - Photo © Flashon Studio - Fotolia.com

We are starting a series of articles describing different pension systems around the world.

History of US Pension

Public pensions began as "promises" made to veterans of the Revolutionary War. Those who served were often informally, and sometimes legally, promised financial security after the conflict. These agreements were much more widely used during the Civil War.

In the 1920s, federal civilian pensions were offered under the Civil Service Retirement System (CSRS). CSRS provided retirement, disability and survivor benefits for most civilian employees in the US Federal government. This was replaced by the Federal Employees Retirement System (FERS) in 1987.

During World War II pension plans firmly took hold. Wage freezes prohibited outright increases in pay and retirement plans were a comparable benefit. The defined contribution plans had become the most popular and common type of retirement plan in the United States.

Plans

Known as retirement plans in the USA, plans may be set-up by employers, insurance companies, trade unions, the government, or other institutions. These allow people to retiree from working life with financial security for the future. Retirement plans in the U.S. are defined in tax terms by the Internal Revenue Service (IRS).

Social Security Program

Social Security is the federal program that provide funds for many social welfare and social insurance programs. Pertaining to retirement, these include: Federal Old-Age, Survivors, and Disability Insurance and Supplemental Security Income (SSI).

For example, an average worker named Mr. Smith, would have his earnings tracked throughout his career. This is tracked by the Social Security Administration by a number assigned to each citizen, known as your social security number. How much Mr. Smith makes during his career helps to determine the monthly benefit which he will be entitled to upon retirement. This amount is known as the Primary Insurance Amount (PIA), the average of the highest 35 years of the worker's covered earnings (before deduction for FICA).

Age of Eligibility

The basic age of eligibility is 65, although this is gradually increasing to 67.

However, full retirement benefits depend on a retiree's year of birth.
Those born before 1938 have a normal retirement age of 65. This eligibility increases by two months for each ensuing year of birth until 1943. After this year of birth until the year of birth of 1955, the limit is standard. After 1955 the retirement age again increases by two months for each year.

It is possible to start benefits before normal retirement age at a reduced benefit. This reduction is 5/9 of 1% for each month (up to 36 months) prior to normal retirement age, and then 5/12 of 1% for each additional month. This formula gives an 80% benefit at age 62 for a worker with a normal retirement age of 65, a 75% benefit at age 62 for a worker with a normal retirement age of 66, and a 70% benefit at age 62 for a worker with a normal retirement age of 67.

It is also possible to delay starting retirement benefits. Retirement credits increase their benefit until they reach age 70.

How to Apply

Applying for Social Security retirement benefits is very easy. You may apply online or by walking into your local Social Security office.

Amount of Benefits

If Mr. Smith retires at 65 and has 42 years with some Social Security covered earnings, he could be eligible for as much $1,615 per month. However, the benefits are complicated and may be compromised by many factors including if there is a spouse, government employment, and other variables. To calculate your own benefits, go to the social security benefit website.

Future of Social Security

There have been very animated debates about the future of Social Security in the United States as benefits are not guaranteed. The program is funded through dedicated payroll taxes called Federal Insurance Contributions Act (FICA). Benefits have been paid almost entirely by using revenue from payroll taxes earning the name "pay-as-you-go". However, in the near future payroll tax revenue is projected to be insufficient to cover Social Security benefits. At this time, the system will begin to withdraw money from the Social Security Trust Fund. By dollars paid, the U.S. Social Security program is the largest government program in the world and the single greatest expenditure in the federal budget. Social Security supports about 40% of all Americans age 65 or older. Proposals to privatize the fund have been hotly debated, most notably during the Bill Clinton and George W. Bush presidencies.

Private Retirement Plans

Defined Contribution Plan in America

A defined contribution plan is an employer-sponsored plan with an individual account for each participant. The accrued benefit from such a plan is solely attributable to contributions made into an individual account and investment gains on those funds, less any losses and expense charges. The contributions are invested and the returns on the investment are credited to or deducted from the individual's account.

Upon retirement, the account provides retirement benefits, most often through the purchase of an annuity. This is the dominant form of plan in the private sector. Money is contributed by the employer and directly deducted from the employee's salary. Employee contribution may be matched by the company. The amount deducted will be monitored by the IRS.

Examples of Defined contribution plan include Individual Retirement Account (IRA), 401(k), and profit sharing plans. The participant is responsible for selecting the types of investments to make. They may choose a small number of pre-determined mutual funds, individual stocks, or other securities. The funds in such plans may not be withdrawn without penalty until the investor reaches retirement age.

The most popular is the 401K, a retirement plan that allows employees to contribute a certain percentage of wages earned into a tax-deferred account to save and invest for retirement. Some employers offer participants matching funds as part of a benefits package or company incentive.

For how this would work for an individual interested in investing in a 401K, let's use the example of a Mr. Smith.
Mr. Smith is paid $40,000 annually. His company offers a 401K program which he enrolls in and is able to contribute 20% of his salary. Mr. Smith's company will also contribute to their plan at 50% of every dollar he contributes up to 6 percent of his salary.
This makes Mr. Smith's yearly contribution $8,000 ($40,000 x 20%).
Mr. Smith's employer's contribution would therefore be $1,200 ( $40,000 x 6% x ½ ) per year.

However, it is possible to lose money in the long term. If Mr. Smith bought shares of a stock fund and it loses money, so does Mr. Smith. There is more risk with these types of funds, and hopefully more rewards.

Defined Benefit Plans in America

A defined benefit plan pays a benefit that will be paid upon retirement. A monthly benefit is allotted equal to the number of years worked multiplied by the member's salary at retirement multiplied by a factor known as the accrual rate. At a minimum, benefits are payable as a Single Life Annuity (SLA) for single participants or as a Qualified Joint and Survivor Annuity (QJSA) for married participants. These funds are paid at retirement and may be adjusted for an earlier or later start. A lump sum distribution may be available in some cases.

Defined benefit plans may be either funded or unfunded.
In a funded plan, contributions from the employer and participants are invested into a trust fund dedicated solely to paying benefits to retirees. The future returns on the investments is not known in advance, so there is no guarantee that a given level of contributions will meet future obligations. Therefore, fund assets and liabilities are regularly reviewed by an actuary in a process known as valuation. A defined benefit plan is required to maintain adequate funding if it is to remain qualified.
In an unfunded plan, no funds are set aside for the specific purpose of paying benefits. The benefits to be paid are met immediately by contributions to the plan or by general assets. Most government-run retirement plans, including Social Security, are unfunded, with benefits being paid directly out of current taxes and Social Security contributions.

For example:
Mr. Smith makes $50,000 as an average salary (based on the best 5 years of earnings)
x 25 years he invested in the plan
x 0.02 (an example fixed percentage of 2%)
= $25,000 per year in pension

Hybrid and Cash Balance Plans

Hybrid plans combine the positives of defined benefit and defined contribution plans. They are treated as defined benefit plans for tax, accounting, and regulatory purposes. The investment risk is also shouldered by the plan sponsor. However, like a defined contribution plan, benefits are expressed in the terms of a notional account balance, and are usually paid as cash balances upon termination of employment. A typical hybrid design is the Cash Balance Plan, where the employee's notional account balance grows by a defined rate of interest and annual employer contribution.

Companies

There are a plethora of companies from which to choose to fund your retirement. (Note that if planning for your retirement through your place of employment, your options may be limited.) Different companies offer different interests and fees, so shop around before picking one.

Expat Benefits

Expats in the US may pay into a private pension plan like a 401K if they are employed with a US company that offers that benefit. They may also be eligible for social security if they live and work in the United States and pay taxes. Expats may also be eligible for pension plans in their own country, dual tax agreements are common.

American expats abroad are eligible for their private pension plan regardless of where they are currently located. U.S. Social Security extends to American citizens and U.S. resident aliens employed abroad by American employers without regard to the duration of an employee's foreign assignment, and even if the employee has been hired abroad. For more information on these agreements and to find what countries are eligible, go to the U.S. International Social Security Agreements.

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