Oran A. Hall, Contributor
Persons leaving the workforce at retirement will switch a salary for a pension.
Some persons leaving the workforce are fortunate to have children who are able to provide for them. Others are able to live off their investment income or business income, but many depend on their pension. Yet, others have little or nothing to live on.
Although a pension rarely covers all of the expenses of the retiree, it makes sense to have a pension, which is the income received during a person's retirement.
It may come from an approved pension arrangement or a non-approved arrangement. An approved arrangement is one that is sanctioned by the government. It is allowed certain rights but carries certain responsibilities.
There are two types of approved pension arrangements: a superannuation fund and a retirement scheme.
The superannuation fund is an approved pension arrangement established by a company or association for the benefit of its employees or members. A retirement scheme is established by a company licensed by the government to transact this type of business.
Any individual who is not a member of a superannuation fund may join a retirement scheme. Some persons refer to it as an individual retirement plan.
Every approved pension arrangement must have a board of trustees or a corporate trustee whose duty is to operate it according to its trust deed and rules in the best interest of the members and their beneficiaries.
The trust deed is a contract between the sponsor and the trustees to manage it according to certain stated conditions.
The rules expand on the contents of the trust deed and normally introduce new items.
Every member of an approved pension arrangement should have an up-to-date copy of the rules.
Most approved pension arrangements have a vesting formula which will state the amount of money, other than the member's own contributions, that is available to provide a deferred pension for the member who chooses to withdraw from the arrangement before reaching normal retirement age.
This situation often comes about due to the retirement of the member.
If, for example, an employee resigns from his job or is made redundant at the age of 50 and the normal retirement age is 65, the employer's contribution to the approved pension arrangement remains and is invested.
He then gets a deferred pension at age 65. Vesting usually occurs after a minimum number of years, five for example.
Pension rights accrue to members of an approved pension arrangement every day, so a monetary value can be determined for these accrued pension rights any day.
The value of accrued pension rights is preserved by not making it available to a withdrawing member in cash.
There are two options: the money remains in the approved pension arrangement to provide a deferred pension to the member; or the money is transferred to another approved pension arrangement to provide a pension benefit for the member at normal retirement age.
There are two types of contributions to approved pension arrangements: required and voluntary.
The required contribution, also called the basic or mandatory contribution, is the stated percentage of taxable salary which each member contributes to the approved pension arrangement.
The voluntary, or optional, contribution is a stated percentage of taxable salary up to which each member may contribute to the pension arrangement.
Two popular types of pension arrangements are the defined contribution, or money purchase, plan and the defined benefit plan. In the defined contribution plan, both the required contribution rate of each member and the contribution rate of the employer on behalf of each member is defined.
Both sets of contributions are invested for the benefit of the member. At normal retirement age, or earlier termination, the member will have three accounts derived from his basic contribution, his voluntary contribution and the employer's contribution, which form the basis for how much pension he will receive.
This determination is usually made by an actuary.
A defined benefit plan has a prescribed formula which states very clearly how the annual pension will be calculated at retirement.
There are several types. One type is based on the average salary of the number of years of pensionable service. This is called the career average salary plan.
The modified career average salary plan is similar to the previous type except that the pension is calculated on the basis of a base year which may change from year to year.
Under the final salary plan, the pension is based on, for example, the final year's salary, the average of the annual salary over the last three years, or some other variation.
The final salary plan generally gives the best pension. Whereas the defined benefit plan applies only to superannuation funds, the defined contribution applies to superannuation funds and retirement schemes.
Oran A. Hall, a member of the Caribbean Financial Planning Association and principal author of 'The Handbook of Personal Financial Planning', offers free counsel and advice on personal financial planning. Send feedback to firstname.lastname@example.org