Definition
An advance funded pension plan is a type of retirement plan where funds are currently set aside with the objective of financing an employee’s pension. These funds are collected during the employee’s working years and invested to accumulate the amount required to pay for the employee’s retirement benefits. The primary goal is to ensure that sufficient financial resources are available when the employee retires, reducing the risk of unfunded obligations.
Examples
- Corporate Pension Plans: Large corporations often set up advance funded pension plans for their employees, managing the investments to guarantee the future payout.
- Government Pension Plans: Some government agencies use advance funded pension plans to make sure that public employees, such as teachers or police officers, receive their pensions in the future.
- Private Sector: Small and medium-sized businesses may use advance funded pension plans as a part of their employee benefit program to attract and retain skilled workers.
Frequently Asked Questions (FAQs)
What is the difference between an advance funded pension plan and a pay-as-you-go pension plan?
In an advance funded pension plan, contributions are made and invested currently to cover future retirement benefits. In contrast, a pay-as-you-go pension plan is funded by current contributions from active employees and employers, which are immediately used to pay current retirees.
Who manages the funds in an advance funded pension plan?
The funds are usually managed by a pension fund manager, an insurance company, or an independent fiduciary, employing investment strategies designed to maximize returns while mitigating risks.
Are there any risks associated with advance funded pension plans?
Yes, the main risks include investment risk, where the return on investments may not meet expectations, and longevity risk, where retirees live longer than anticipated, causing the funds to be stretched.
What types of investments are commonly used in advance funded pension plans?
Typically, these plans involve a diversified portfolio of investments, including stocks, bonds, real estate, and other asset classes, designed to meet long-term return objectives.
Is it mandatory for an employer to offer an advance funded pension plan?
No, it is not mandatory. However, offering a retirement plan can be an attractive benefit for employees and may be a part of a competitive compensation package.
- Defined Benefit Plan: A type of pension plan where the benefits are calculated based on factors such as salary history and duration of employment.
- Defined Contribution Plan: A retirement plan where the amount of the employers’ annual contributions is specified.
- Pension Fund: The pool of funds managed to ensure the payment of pension benefits.
- Fiduciary Duty: A legal obligation of the plan managers to act in the best interest of the plan participants.
- ERISA (Employee Retirement Income Security Act): Federal law that sets minimum standards for pension plans in private industry.
Online References
- Investopedia - Advance Funded Pension Plan
- U.S. Department of Labor - Pension Plans
- IRS - Retirement Plans
Suggested Books for Further Studies
- “The Pension Trustee’s Handbook” by Robin Ellison
- “Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control” by Malcolm McTaggart
- “The Future of Pension Management: Integrating Design, Governance, and Investing” by Keith P. Ambachtsheer
Fundamentals of Advance Funded Pension Plans: Retirement Planning Basics Quiz
### What is the primary goal of an advance funded pension plan?
- [ ] To garner immediate tax benefits.
- [x] To ensure that sufficient financial resources are available upon employee's retirement.
- [ ] To increase employee turnover.
- [ ] To defer compensation increases.
> **Explanation:** The main goal of an advance funded pension plan is to ensure that sufficient financial resources are available to fund retirement benefits when an employee retires.
### Which of the following best describes a key advantage of an advance funded pension plan?
- [ ] Guaranteed high investment returns.
- [x] Provision of retirement security by accumulating funds in advance.
- [ ] Lesser regulatory requirements.
- [ ] Complete immunity from economic downturns.
> **Explanation:** Advance funded pension plans provide retirement security by accumulating and investing funds during the employees' working years to meet future pension liabilities.
### What risk involves the possibility that retirees may outlive their pension funds?
- [ ] Market risk
- [x] Longevity risk
- [ ] Operational risk
- [ ] Credit risk
> **Explanation:** Longevity risk refers to the risk that retirees may live longer than expected, thereby depleting the pension funds accumulated.
### In contrast to advance funded pension plans, how are pay-as-you-go pension plans funded?
- [x] From current income or contributions to pay current retirees.
- [ ] From company profits stored until employee retirement.
- [ ] From government subsidies only.
- [ ] From loans taken by the company.
> **Explanation:** Pay-as-you-go pension plans are funded using current income or contributions to cover the pensions of current retirees.
### Who is typically responsible for managing the funds in an advance funded pension plan?
- [ ] Employees themselves
- [x] Pension fund managers or fiduciaries
- [ ] The government
- [ ] The employer’s internal finance team
> **Explanation:** Pension fund managers or fiduciaries are responsible for managing the investments of an advance funded pension plan to ensure adequate returns and risk management.
### An advantage of advance funded pension plans for employers is that they:
- [ ] Lower the immediate payroll costs.
- [x] Help attract and retain skilled workers.
- [ ] Automatically adjust to inflation.
- [ ] Provide unrestricted fund usage.
> **Explanation:** Offering an advance funded pension plan can help employers attract and retain skilled workers by providing a valuable retirement benefit.
### Which regulatory act sets standards for pension plans in private industry in the United States?
- [ ] SOX
- [x] ERISA (Employee Retirement Income Security Act)
- [ ] HIPAA
- [ ] FMLA
> **Explanation:** ERISA (Employee Retirement Income Security Act) is the regulatory act that sets standards for pension plans in private industry in the United States.
### What type of pension plan specifies the employer’s annual contributions rather than the benefit received?
- [x] Defined Contribution Plan
- [ ] Defined Benefit Plan
- [ ] Target Fund Plan
- [ ] Cash Balance Plan
> **Explanation:** In a Defined Contribution Plan, the employer's annual contributions are specified rather than the benefits received by the employee.
### Which term refers to the pool of funds managed to ensure the payment of pension benefits?
- [ ] General Reserve Fund
- [ ] Emergency Fund
- [x] Pension Fund
- [ ] Development Fund
> **Explanation:** A Pension Fund is the pool of funds set aside and managed to ensure the payment of pension benefits to employees upon retirement.
### What is the fiduciary duty related to pension fund management?
- [ ] To maximize employer profits.
- [ ] To equally distribute funds among all employees.
- [x] To act in the best interest of the plan participants.
- [ ] To minimize the number of retirees.
> **Explanation:** Fiduciary duty in pension fund management requires that the managers act in the best interest of the plan participants.
Thank you for exploring the comprehensive details about advance funded pension plans and taking the challenge of our sample exam quiz questions. Keep up your hard work in securing a solid foundation in retirement and financial planning!
