US Pension System

Pension - a periodic income or annuity payment made at or after retirement to an employee who his become eligible for benefits through age, earnings, and service. Benefits also may be paid in the event of death, total disability, or job termination. Payments are usually in monthly installments. In private pension plans, benefits are provided through the accumulation of funds set aside by the employer and sometimes by the employees. Other private plans providing retirement benefits are deferred profit-sharing plans and thrift and savings plans.

The American pension movement has evolved partly as a result of a significant economic, political, and social development: the progressive increase in the number and proportion of the population aged 65 and over. It is estimated roughly that by the year 2025 aged persons in the United States will number more than 50 million and total about 16% of the population. In 1978 these figures were about 24 million and 11%. This development brings into focus the need to provide some measure of financial security for individuals who face the risk of reduced earning power at an advanced age. This risk is met by private pension plans — along with personal savings in various forms — and government-sponsored programs such as Social Security.

This discussion deals exclusively with private single-employer pension plans in the United States. However, much federal legislation is interwoven in pension programs. The Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA) directly affect the administration, accumulation, and disbursement of pension funds. The purpose of such federal regulation is to assure that every worker who has been promised pension benefits will in fact receive them.

Types of Pension Plans

Pension plans may be identified according to their characteristic features. They may be:

- contributory or noncontributory;
- fixed or variable benefit;
- group or individual;
- insured or trustee;
- private or public; and
- single- or multi-employer.

Moreover, they may be categorized as qualified or unqualified under the Internal Revenue Code. Under ERISA, an employer must select a funding agency. Therefore, pension plans usually are classified in terms of the funding agencies that accumulate and administer employer and sometimes employee contributions. If the funding agency is a life insurer, the plan is called an insured plan. If the funding agency is a commercial bank or an individual trustee, the plan is called a trust fund plan. If both funding methods are used, the plan is called combination or split-funded.

Insured Plan

Under this plan, contributions are transmitted to an insurance company, which invests them and pays the retirement benefits. Insurer guarantees vary according to the contract or funding instrument selected. Insurers use two types of funding instruments:

- the allocated-funding contract, where cash-value life insurance or deferred annuities are purchased immediately for each participating employee; and
- the unallocated-funding method, in which funds accumulate and are used later to buy annuities for retiring employees.

Allocated Funding

Three types of insured allocated - funding instruments are available. These are:

- individual life policies,
- group permanent life, and
- group deferred annuities.

Designed for small firms, the individual life-policy plan is funded through individual insurance, such as whole-life or retirement income contracts that deliver benefits at retirement. Premiums are paid to the insurer, which pays retirement benefits. Both the individual life and group permanent life plans provide for protection in the event of death.

In the group deferred-annuity plan, single premium annuities are purchased yearly and credited to each individual's account. If, for example, a fully paid annuity of $40 a month is purchased each year, an employee with 30 years of service at retirement will have a guaranteed income of $1,200 a month.

Unallocated Funding

These instruments, which make up more than 90% of all insured plans, were designed by insurers to compete better with banks as pension-funding agencies. They include:

- group deposit administration (DA),
- immediate participation guarantee (IPG), and
- guaranteed investment contracts (GIC's).
Retirement benefits from these plans are paid either from annuities or directly from trust funds.

Under a DA plan, annuities are not purchased immediately. Instead, insurers accumulate and invest the employer's deposits. These funds are used later to purchase annuities for employees at retirement. Interest and annuity purchase rates are temporarily guaranteed by the insurer for all funds deposited.

Under a IPG plan, the pension fund is credited annually with interest earned, charged with administrative expenses, and credited or charged with mortality gains or losses. With IPG, the employer participates immediately and fully in the plan's favorable or unfavorable investment and mortality experience. At retirement, the participant is paid directly from the fund.

In DA plans, the insurer guarantees by contract the preservation of principal, an interest accumulation rate, and a schedule of annuity purchase rates. Benefits payable to retired employees for whom annuities have been purchased are also guaranteed. Annual contributions must meet the minimum funding standards established by ERISA.

Another variation of the DA plan is the separate account that allows employers to invest a part of their deposits in a variety of financial instruments without subjecting these funds to restrictive state insurance regulations. The insurer is free to select among such investment media as stocks, bonds, short-term securities, and real estate. The federal Securities and Exchange Commission, however, requires that the employees' contributions, if any, be included with the insurers' general investment fund and accumulate at a guaranteed minimum rate.

Guaranteed Investment Contracts (GIC's) were introduced by insurers to attract large pension funds. Under these contracts, after receiving a lump-sum payment, the insurer guarantees a fairly high rate of interest for a number of years. Along with various contractual arrangements GIC's offer many annuity or other payout options for the contract holder.

Finally, life insurers introduced a contract under which the plan sponsor can choose to utilize only the investment services of the insurer, dispensing with administrative service, disbursement services, and traditional guarantees.

Trust Fund Plan

The trust is the dominant instrument for the funding of pension benefits. It is the favored arrangement of multiple-employer and union pension plans and is used widely by single-employer plans. Using unallocated funding, the trust is the most flexible of all funding arrangements and permits unlimited access to all types of investments, including equities.

Under a trust plan, the employer deposits funds with a trustee-usually a bank but sometimes an individual or group of individuals. Acting as a fiduciary, the trustee invests the money, accumulates the earnings, and ordinarily performs administrative tasks, such as sending out pension checks. The trustee also renders periodic accounting to the employer and to the plan administrator. In sum, the functions of the trustee in a trust-fund pension are normally confined to the management and disbursement of the accumulated funds. The trustee does not participate in the development or administration of the plan. He generally does not provide any actuarial services, either before or after the plan is established.

The funding arrangements described may be combined in various proportions to fund a defined-benefit pension plan. These are called split-funded or combination plans and customarily include life-insurance contracts with an unallocated fund of assets. The objective is to combine the guarantees of an insured plan with certain investment opportunities of a trust.