Retirement plan is a financial adjustment launched to replace the employment income on retirement.
Different types of retirement plans:
Retirement plans are divided into defined benefit and defined contribution as per how benefits are determined.
Defined contribution plan: As per Internal Revenue Code section 414, this plan is an employer promoted plan for each participant with an individual account. The accumulated benefit from such a plan is completely attributable to contributions created into an individual account and investment gains on those funds, reduced any losses and expense charges.
The contributions which are invested in somewhere and the earnings are deducted from the individual’s account. This plan uses the participant’s account to provide retirement benefits on retirement, often by the purchase of an annuity. Defined contribution plans became more comprehensive in recent years and in private sector new the primary from of the plan.
Examples of defined contribution plans such as 401(k), Individual Retirement Account(IRA), Profit sharing plans. Money will be contributed from employer contributions, employee salary deferrals etc.
Defined benefit plans: Generally it is referred to as pension in US. In this benefits are paid by defined benefit plans from a trust fund using a particular formula set forth by the plan sponsor. In other words, the plan defines a benefit that can be paid upon retirement.
Defined benefit plans can be either unfunded or funded. In funded plan contributions are invested in to trust fund which are contributed by participants and employer and that contributions dedicated to pay benefits to retirees in a given plan.
The future benefits and the future returns on investments that will be paid or not known in advance, a given level of contributions whether will meet the future commitments or not. There that is no guarantee. Therefore, fund liabilities and assets are periodically analyzed by an actuary in a process called as valuation.
In an unfunded plan funds are not set aside for the particular purpose of paying benefits. In this the benefits which are paid are met as soon as possible by contributions to the plan or by common assets. Social security and most government run retirement plans are unfunded. Most non qualified plans are also unfunded.