What comes to mind when you hear the word “pension”?
For many, a pension allowed your parents to retire comfortably at 65 with a steady stream of money coming in each month.
For others, pension might mean broken promises from formerly successful US businesses, or the primary cause of debt ridden state governments.
Pensions have been around since the US Revolution. Just as pensions were used to attract soldiers to join and remain with US forces through the war, US employers have long used pensions to recruit and retain quality employees.
Government-required pension plans
Unlike many countries, the only government-required pension plan for private businesses in the United States is Social Security. Social Security is a US government run pension program that is funded through taxes. Although the nuances of Social Security can be complicated, the overarching structure includes a basic, two-step process:
- While US workers are employed, they pay taxes that go directly into the Social Security system.
- When those workers retire or become disabled, those workers receive monthly Social Security benefits based on reported earnings.
Many local, state, and federal government agencies offer pension programs for government employees; however, Social Security remains the only US pension program that private businesses are required to participate in.
If you have employees from foreign countries, this may be unusual from them. For much of the developed world, government required pension programs are common, and employees include such programs in their retirement planning.
The Melbourne Mercer Global Pension Index tracks and rates pension programs across the globe according to sustainability and value of the benefits. If you have employees from countries that rank high on this index, you may want to prepare them for the lack of pension benefits in the US, and cover alternatives more commonly available in the US.
The US ranks low for a number of reasons. First, the one government-required pension program (Social Security) is currently scheduled to run out of money by 2034. Further, for those who are currently receiving their full Social Security benefit, it generally isn’t enough to live on.
The purchasing power of a Social Security beneficiary has dropped 34% since 2000. In 2019, the average Social Security monthly benefit is $1,461 ($17,532 annually). Few would argue that this amount of money makes for an easy retirement.
If the Social Security program runs out of money in 2034, it’s anticipated that the already low benefit paid out will drop more than 20% immediately. It’s no wonder why the US pension system ranks low on the global index.
Although the government doesn’t compel pension programs, the US has a rich history of private pension programs that many retired Americans currently rely on, and others are planning on.
Employer-funded, private pension plans in the US rose to popularity during World War II. They remained the most popular type of employee retirement plan in the US through the 1980s. The traditional type of employer-funded, private pension plan is called a defined benefit plan.
“Defined benefit plans” provide a fixed, pre-established benefit for employees at retirement.
This fixed or defined amount allows employees to know exactly what they will receive in retirement amount because you, the employer, contribute a set amount of money each month towards employees’ pension accounts.
Most employers choose one of two options when defining the benefit to contribute to pension accounts each month:
- A fixed contribution, or
- A fixed percentage of the employees salary
Generally, your employees do not contribute to defined benefit plans. The entire pension benefit is provided by the company. There are some hybrid models that allow employees to contribute to pension plans, but most employee-funded retirement options occur under non-pension plans like 401(k) and IRA plans.
If you offer a defined benefit plan, you are required by law to hold your contributions in trust, separated from your other business funds. This ensures that pension contributions are held exclusively for your employees. When held in a pension trust, those funds become unavailable for business use, or to creditors in the event of a lawsuit or bankruptcy.
When an employee reaches retirement age, the pension trust begins to distribute the funds on a monthly basis to the retired employees as a fixed benefit. Defined benefit pension plans are attractive to employees because they don’t have to contribute any money towards the retirement fund, and employees know the exact amount to expect upon retirement. 401(k) and IRA plans are less predictable because they are invested in markets that constantly fluctuate.
Defined benefit plans are attractive to your employees because:
- They accrue substantial benefits within a short amount of time
- The benefit is predictable
- The benefits are not subject to market fluctuations
Defined benefit pension plans are attractive to employers because:
- They help attract and retain employees
- Employers can contribute and deduct more than other retirement plans like 401(k) and IRA plans
- Employers can use plans to accomplish business goals such as early retirement benefits
Although defined benefit pension plans offer attractive perks to both employers and employees, downsides exist:
- Defined benefit pension plans are the most expensive and complex retirement plans to operate
- Employers are subject to excise taxes if minimum contributions are not met
- Employers are subject to excise taxes if excess contributions are made
The expense and the administrative complexities are likely contributors to the dramatic drop in private pension plans offered in the US since the 1980s. A 2019 report indicates that only 21% of US employers offer a traditional pension plan. Compare that to the early 1990s when over a third of private US employers offered pension plans, and the 93% of employers who currently offer 401(k) plans.
Pensions are no doubt the most expensive retirement benefit you can offer your employers, but pensions remain even more unattractive to employers today because of the aging Baby Boomer population.
Because Baby Boomers are retiring at a rate quicker than new employees are taking their place, the need for one new worker to fund the pension of two or three retiring workers is becoming an increasing problem. Current birth rates, death rates, hiring rates, and retiring rates suggest this problem is not going away.
If you are able to afford and fund a defined benefit pension plan, you are in a unique position that few employers can match. If you can’t afford a traditional pension, you could consider a modern alternative: Simplified Employee Pensions (SEP) plans.
SEP plans allow you to contribute an amount up to 25% of each employee’s pay for that employee’s retirement. Similar to defined benefit pension plans, SEP plans are employer-funded, without contribution from the employee. SEP plans are much easier to set up, and do not require the administrative complexity associated with traditional pensions. If you are interested in an SEP plan, you must follow a few simple steps and rules:
- Establish the plan by adopting IRS Form 5305-SEP
- Contribute money into traditional IRA account (SEP-IRA) for each individual employee
- Employees must be immediately 100% vested
- Contribute to each employee equally
SEP plans are a great alternative to traditional pension plans if you don’t want the administrative burden and expense associated with traditional plans. Additionally, they allow you to increase and decrease your contribution if your business is strapped for cash. If you have an employee base that is unlikely to contribute to a modern retirement account like a 401(k) or IRA, but you want to help those employees save for retirement, an SEP plan might be a good alternative.
Retirement savings accounts
Unlike employer-funded pension plans, retirement savings accounts (e.g. 401k, IRA, etc.) are funded by employees. You have the option to contribute to your employees’ plans and may choose to do so as an incentive for employees to participate; however, retirement savings accounts are primarily employee-funded.
To incentivize employees to participate in a 401(k), you may offer to match employee contributions up to a certain percentage. This is attractive to employees because your match accelerates employee retirement savings.
For example, assume you match employee 401(k) contributions up to 10% of the salary. An employee who makes $50,000 per year and contributes 5% of his or her pay to the 401(k) plan ends up contributing $5,000 per year to retirement instead of the $2,500 personally contributed:
Employee contribution: 5% of annual salary
Without employer match:
$50,000 x .05 = $2,500 in annual contribution to 401(k)
With employer match:
$50 x .05 = $2,500 + $2,500 (employer match) = $5,000
Healthy employer matches are strong incentives when recruiting and retaining quality employees. If you can match, or even partially match, you offer an incentive that many US businesses do not offer. A recent study by the US Bureau of Labor Statistics found that:
- 49% of US employers offer no 401(k) match
- 41% of US employers match a percentage of employee contributions up to 6% of the employees’ salaries
- 10% of US employers match a percentage of employee contributions at 6% or more of the employees’ salaries
The study found that the median employer contribution is a 3% match.
401(k)s aren’t the only type of employee-funded retirement savings account. An evolving number of retirement accounts exist for employees to choose from:
- Individual Retirement Arrangements (IRAs)
- Roth IRAs
- 403(b) Plans
- SIMPLE IRA Plans
- Payroll Deduction IRAs
- Money Purchase Plans
Retirement planning has become a heated topic in the US. A Northwestern Mutual study showed that 22% of Americans have less than $5,000 in savings for retirement. 5% indicate they have between $5,000 and $24,999, and only 16% say they have over $200,000. Almost half, 46%, don’t know how much they have saved.
Given Social Security isn’t capable of covering a comfortable retirement, employers are smart to think about their employees’ retirement options. This includes educating your employees and offering viable plans for them to participate.
If you have the financial stability to offer a traditional pension plan, you would certainly have a competitive edge over the many employers who are abandoning such employer-funded plans.
If you can’t risk a defined benefit plan, the newer SEP plan might be a good alternative that allows you to fully fund retirement, but gives you the flexibility to lower contributions in times of economic strain. If pensions are off the table, consider a 401(k), IRA, or other fixed contribution option to show your employers and recruits that you care about their retirement benefits.