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
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. Labor unions, the government, or other organizations
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.
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 resemblance
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.