What is the difference between pay as you go pension plan, personal pension plans, fully funded pension plans, and private pension plans? and what kind does Social security fall under? Retirement plan terminology can be extremely confusing. Here is a short primer from a U.S. perspective:
Retirement Plan: Any program designed to provide income in old age.
Defined Benefit Plan: A retirement plan which is designed to provide a set benefit at retirement. Contributions are typically adjusted annually to ensure that the benefit is eventually funded. Example: A pension plan where the benefit is $50/month for each year of service with a company; a person working for 20 years could expect to get 20 x $50 = $1,000/month. This is often referred to as a "pension plan"
Defined Contribution Plan: A retirement plan which is designed to provide a retirement benefit based on a set contribution amount. Example: A company's 401(k) allows savings up to 10% of pay and matches the first 5%. A person making $40,000/year could contribute up to $4,000 and receive $2,000 as a match in each year. The ultimate benefit at retirement is these accumualted contributions with interest.
Private pension plans: This phrase is used to distinguish private versus public sector plans or employer sponsored versus government. IBM's retirement plan is a private pension plan. The New Jersey State Employees' Retirement Plan is a public sector plan. Social Security is a government sponsored plan.
A personal pension plan is a retirement program like an IRA or a Keogh, that is not sponsored by an employer or government entity.
Pay as you go vs. Fully funded refers to the financial status of a defined benefit plan and how contributions are determined:
Pay as you go is a description of a contribution policy for a defined benefit plan. A plan that is funded on a "pay as you go" basis means that no money is invested for the plan, as retiree benefits become due the plan sponsor makes the payments directly. No assets are held so if the plan sponsor goes bankrupt, the retirees and any other participants who are due benefits stand in line with the other creditors. This is an illegal funding method for broad based private pension plans in the US.
Fully funded means that a pension plan has enough asset to totally pay off benefits earned to date; if no one earned any more benefits in the future, no additional money is expected to be needed to pay for current benefits. Retirees and other beneficiaries can have great confidence that even if the plan sponsor goes under, their benefits are safe.
Social Security is basically a pay as you go program. Historically, FICA taxes have been set to just about pay for current benefit payments to retirees. If a big influx of new retirees were to come in, the federal government has the ability to increase the FICA tax rate to cover the increased costs.
Since the early 1980's the FICA taxes have been set higher than current benefit payments in order to accumulate money to pay for the baby boomers when they retire. The idea was to put that money aside an use investment earnings on it to reduce the FICA tax increases that would have otherwise been necessary. The program has been no where near fully funded.
In fact, this is a sort of shell game. The only investments Social Security can buy with this money is US govt bonds. So Social Security is giving its extra assets to the government to run the country with the promise that the government will pay it back from future taxes. You are paying Higher FICA now so that you don't pay higher FICA later. But the higher FICA is funding lower taxes now which will have to rise later to fund the investments Social Security made with the higher FICA. |
