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.

  • Surrender value. Asking for the money saved to be paid back, together with the related return is known as “redemption”. This option for pension plans is more restrictive, which is why pension plans are referred to as being “non-liquid”, i.e. they cannot be cashed in at any given moment. This is only possible when the conditions for which they were taken out have been met. Examples include being unemployed, having reached retirement age, or suffering a serious illness or disability. Generally speaking, if the owner dies, the rights vested under the pension plan pass on to their legal heirs or whoever else has been designated beforehand.

    In contrast, a retirement plan is regarded as a liquid product, since the funds can be surrendered at any time, either by meeting certain contractual requirements or by paying a penalty. In the event of the policyholder’s death, the sum insured is also passed to the beneficiaries of the policy or the deceased’s heirs.

  • Return. In the case of both the pension plan and the retirement plan, the rate of return depends on the level of risk assumed by each customer. The pension plan manager normally takes on more risk by investing in funds with a higher return. However, this depends in all cases on the profile of the worker in question and market conditions. As this is a product that is surrendered in the long term, any losses or low yields are more likely to be offset over time.

    As for retirement plans, the return is normally a set value or a minimum or guaranteed sum, since the insurers invest the capital in a conservative manner and avoid any risks that might affect their own liquidity in the event of having to pay the funds back to the customer. That said, it is becoming more common for customers, according to their particular profile, to choose the level of risk according to their preferred mix of return and security.

  • Tax treatment. The public administration in certain countries aims to encourage the public to save for retirement. Therefore, tax benefits may be offered for both making contributions and surrendering pension plans. Deducting annual amounts in the tax return is one of the most common financial benefits.

    In contrast, there is generally no tax relief for contributions to retirement plans. However there are deductions on surrender values, as tax is normally only paid on the return obtained.

    In any event, as explained above, the tax treatment of one product or another will depend on the tax measures of the country in question, and on whether the owner or the beneficiary surrenders the plan, or the money is taken in either a lump sum or an annuity.

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