What it is:
A pension plan is an arrangement to provide employees with an income when they are no longer earning a regular income from employment.
How it works (Example):
A pension plan is usually a type of retirement plan that gives employers the opportunity to make a contribution to a fund set aside for an employee's future benefit. The pool of funds is invested on behalf of the employee, on a tax exempt basis, and is intended to yield a stream of payments to the employee upon retirement.
By allowing the employer to make the payment into the employee's pension plan in this way, the employee is deferring a portion of his or her income to a future time.
There are two main types of pension plans. One type is defined-benefit plans, where the employee receives a specific amount upon retirement regardless of the performance of the investment pool. The other type is a defined-contribution plan, where the employee receives an amount based on the performance of the investment pool.
In accordance with the US Internal Revenue Service code, the amount of the tax-exempt contributions into a pension plan is limited based on the income levels of the employee.
Why it Matters:
Pension plans can include a variety of types of contributions in addition to cash payments. For example, a pension plan may include profit-sharing plan, a stock bonus plan (usually deferred until retirement so that the contribution is taxed at the retirement tax rate) and even an employee stock ownership plan.