Pension plans and retirement plans are similar sounding terms, they both involve a saving mechanism and they share a common purpose. Given these similarities, it's not always easy to distinguish between them. To help you in this, here's an explanation of what each plan consists of and how to identify them.
One of the most common aims shared by workers is to enjoy a stable financial situation when they reach the end of their working life. To help them achieve this, there are various savings and investment vehicles to choose from, each of which is used to begin to accumulate the necessary funds for the future. Two of the most popular options, which also give rise to the most doubts (as they are often considered incorrectly to be synonyms) are pension plans and retirement plans.
However, despite both being designed for the same purpose (to have a source of financial resources in retirement), in reality each has a specific connotation. To differentiate between them, we first have to understand the concepts of pension and retirement.
A pension is a benefit or an amount of money that a person may receive on a regular basis over a certain time to which they may access for a particular reason, e.g. retirement, unemployment, surviving spouse and disability. Meanwhile, retirement refers to compliance with a requirement (normally either age or years worked) whereby a person may stop working and receive (and rightly so) a pension. As we can see, the two terms are closely related.
How does a pension plan work?
Pensions plans are financial products for investment and long-term savings to which customers make regular or one-off contributions. In turn, the managers of the plans invest the contributions in financial assets to generate a return, mainly through pension funds. The entity administering the fund normally deducts a fee, as does the company responsible for the custody of the funds.
On retirement, the customers receive the amount saved plus the return generated to date. They may choose between receiving a lump-sum payment or an annuity (a regular payment). Depending on the country in question, local legislation might restrict the amount that people may contribute each year to a pension plan.
If you would like to learn more, this article (in Spanish) on the Tu Futuro Próximo website (a blog produced by Santander Consumer Spain) tells you all you need to know about pension plans.
How does a retirement plan work?
A retirement plan is actually a life insurance policy and it works as such, except with the aim of saving to insure a sum over a particular period of time. Policyholders pay a given amount, either regularly or through a single premium, to obtain coverage for specific events such as, in this case, retirement. On the policy maturity date, the policyholder receives the amount saved plus the return offered by the insurance company.
The three differences between a pension plan and a retirement plan
As explained above, the main difference is the nature of each product: a pension plan is a financial product for saving and investment, while a pension plan is an insurance contract. However, at this point, you might be wondering how one plan works compared with the other. So, let’s focus on three practical questions to highlight the differences even further.