An employer-sponsored retirement plan is a workplace benefit offered by some companies to help provide workers with income in retirement. Employer-sponsored plans take different forms, but fit primarily into two categories: defined benefit plans, which promise workers a specific amount of retirement income, and defined contribution plans, which don’t guarantee any retirement income but instead enable workers to save for their own retirements, often with some employer assistance.
Employer-sponsored retirement plans are very common, with the Bureau of Labor Statistics reporting 94% of civilian workers had access to some type in 2019. However, there are pros and cons workers should consider before using a workplace retirement plan to save for their later years.
Types of Employer-Sponsored Retirement Plans
Employers generally determine the type of retirement savings plan they want to offer, with workers often able to decide whether to opt in.
Some of the most common types of employer-sponsored retirement plans are the following:
Vesting retirement plans
Some workplace retirement plans offer employees ownership only after they fulfill certain requirements, such as working for a certain number of years.
In defined contribution plans, where employers contribute their own money, worker contributions are always 100% vested. However, if employees make matching contributions, the employee doesn’t always own them right away.
Instead there may be a vesting schedule that transfers ownership to the employee either over time (on a graded vesting schedule) or all at once after the employee fulfills a specific requirement (on a cliff vesting schedule). Generally employees must be fully vested and have 100% ownership of employer contributions after three years under a cliff vesting schedule or after six years under a graduated schedule.
Vesting is also common in defined-benefit plans, in which employers guarantee a certain amount of retirement income. Here employers may also offer a cliff vesting schedule, requiring employees work for up to five years before becoming 100% vested in employer-funded benefits, or a graduated vesting schedule, under which it may take up to seven years for employees to become 100% vested.
Nonqualified Retirement Plans
Nonqualified retirement plans are employer-sponsored plans that do not have to meet guidelines set by the Employee Retirement Income Security Act (ERISA).
These plans are often provided to highly compensated workers as an employee benefit. Unlike with qualified retirement plans, employers contribute to them with after-tax dollars. Nonqualified plans are not subject to annual contribution limits, there are far fewer reporting requirements, and, unlike qualified plans, they are not required to benefit all employees equally.
Qualified Retirement Plans
Qualified retirement plans are tax-deferred retirement plans subject to Employee Retirement Income Security Act (ERISA) rules as well as IRS guidelines. These requirements are extensive, with plans generally subject to minimum participation requirements, annual contribution limits, and vesting requirements. Employers and employees can contribute to them with pre-tax dollars, but employers are subject to reporting, disclosure, and funding rules.
There are two types of qualified retirement plans: a defined benefit plan and a defined contribution plan.
The two types of qualified retirement plans are defined benefit plans and defined contribution plans.
1. Defined Benefit Plan
A defined benefit plan is an employer-sponsored retirement plan that guarantees an employee will receive a certain amount of money in retirement. Also called pension plans, defined benefit plans require employers to assume the responsibilities and risks of investing and managing retirement funds for employees.
Defined benefit plans can take the form of annuities that provide fixed monthly payments or single lump sum payments to employees. The amount of money an employee receives is determined by a preset formula, generally based on years of service and salary. In many cases, if an employee passes away, his or her surviving spouse is entitled to receive benefits from the plan.
2. Defined Contribution Plan
Defined contribution plans are more common than defined benefit plans, especially among civilian workers.
Under most of these plans, including 401(k)s and SIMPLE IRAs, employees are able to contribute a portion of their salary with pre-tax dollars but aren’t required to do so. They can choose their own investments from among those offered by the plan administrator. Employers may either choose whether to make contributions or, in the case of a SIMPLE IRA, make mandatory contributions based on a preset formula. A SEP IRA is also a type of defined contribution plan, but only employers can contribute to it.
With defined contribution plans, employees shoulder the risks of investing and are largely responsible for ensuring their own retirement security. Employees are not guaranteed any minimum income, and account balances fluctuate depending on changes in the value of investments.
Pros and cons of employer-sponsored retirement plans
For those with employers offering retirement plans, it’s important to weigh the pros and cons of participating in a workplace plan versus other types of retirement accounts.
- Some plans offer guaranteed income: Defined benefit plans remove the risk of retirement investing for employees.
- Employers often provide contributions: This is free money via employer matching that workers shouldn’t pass up.
- Signup is simple: Some companies enroll workers in retirement plans automatically, while others require workers to complete some paperwork. It can be easier to enroll in a workplace plan than to open a brokerage account and save independently.
- Contribution limits are often higher: Workplace 401(k) accounts and other similar defined contribution accounts have higher limits than many tax-advantaged accounts such as IRAs and HSAs.
- Investing is often automatic: Workers can sign up to have contributions to their retirement accounts taken directly out of their paychecks, ensuring money is invested regularly. In some companies, contributions are automatically withdrawn unless workers opt out.
- You may need to work a certain number of years to become eligible: This could trap you in your job or mean you need to consider other investing options if you don’t plan to remain with your employer long enough to qualify.
- You have less flexibility in investments: If you have a 401(k) or similar defined contribution account, you may be limited to investing in a select few funds offered in your workplace account. IRAs and other brokerage accounts likely offer more options.
- Some plans come with higher fees: You may have to pay a management fee for your employer plan.
For most people the advantages of participation in an employer-sponsored plan outweigh any disadvantages. However, you’ll need to consider the type of plan, the availability of an employer match, and the other options available to you to determine what’s best for your situation. Since your retirement security depends on your choices, it’s worth researching each plan carefully to make the most informed choice.