What is a Pension?
A pension plan is an employer-sponsored retirement plan that promises employees a defined benefit during retirement.
🤔 Understanding pensions
A pension plan is a retirement plan in which an employer guarantees a defined benefit to employees. The employer contributes to a pool of funds, which is invested for the benefit of employees; the proceeds of those investments are then paid out to employees as a benefit in retirement. A pension plan is different than a defined-contribution retirement plan, such as a 401(k), where employees put aside some of their income for retirement (and where the employer may match some portion of employee contributions). Pension plans place the investment risk on the employer rather than the employee. This is because pensions are a “defined-benefit plan,” meaning employees are promised a certain amount in retirement — regardless of the return on the investments.
Imagine Steve goes to work at a company that offers its employees a pension plan. Steve immediately enrolls in the plan. Each month, Steve’s employer contributes to the pension plan, and the employer invests those contributions, usually in some mix of stocks and bonds. Because Steve’s pension plan is a defined-benefit plan, he’s promised a certain amount of money every month in retirement, no matter how the investment performs.
A pension plan is like your employer planting a vegetable garden for you (with a guarantee behind it)…
While you work, your employer plants seeds. Your employer hopes those seeds will grow enough food to feed you what it’s promised during the winter (your retirement). But, even if some of the crops die or get eaten by animals — your employer is on the hook. If the garden doesn’t provide enough, they’ll have to buy you food from the store. The risk is all on them.
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What are the different types of retirement plans?
When it comes to employer-sponsored retirement plans, there are two primary options that an employer might offer: A defined-benefit pension plan or a defined-contribution plan. Both can provide an income to employees when they retire, but how they do so is a little different.
A pension plan is a defined-benefit plan. Under this type of plan, the employer promises that an employee will get a certain monthly income during their retirement. The employer invests the money in the pension plan. Regardless of how the investments perform, they’re still on the hook for the monthly benefit they’ve promised the employee. If the investments perform poorly, the money will have to come out of the company’s pocket.
Defined-benefit plans used to be very popular in both the private and public sectors. But, over the past several decades, their popularity has decreased in the private sector. Defined-benefit plans are still widely used for government employees. In fact, 90% of state employees still have access to defined-benefit plans.
A defined-contribution retirement plan is an employer-sponsored plan in which the employee contributes a certain amount of their pre-tax salary to a retirement plan — It’s most often a 401(k) plan. In some cases, the employer will match the employee’s contribution up to a certain percentage.
Contributions to a defined-contribution plan are usually invested, as they would be in a defined-benefit plan. With defined-contribution plans, however, the employee is the one who makes the investment decisions — and takes the risk. In the end, an employee’s benefit during retirement is dependent on the performance of the investments. If the investments perform poorly, that means less money for the employee when they retire. But, if the investments over-perform expectations, then the employee reaps all the rewards as well.
Which is better: A defined-benefit pension or a defined-contribution retirement plan?
Different retirement plans will be better or worse for employees or employers depending on a number of factors. Defined-benefit plans and defined-contribution plans were initially meant to work together. Retirement benefits were intended to come from three sources (often referred to as the three-legged stool of retirement): an employer pension, personal retirement savings, and Social Security.
Most employers have opted to contribute to their employee’s retirement by matching some funds in their 401(k) rather than by providing an employer-sponsored pension. This could be because they take on less risk than they would with a pension plan — since they don’t promise their employees a certain amount of money for retirement.
Unfortunately, most employers will not give you the option of choosing between a defined-benefit or a defined-contribution plan. Most employers today provide only defined-contribution plans to their employees. This means they’re agreeing to contribute a certain amount to your retirement (usually matching your employee contribution up to a certain percentage), but aren’t guaranteeing that you’ll get a certain monthly income in retirement.
How do pension plans work?
If an employer offers a pension plan, they will contribute money on behalf of their employees. Employees may also have the option to invest in their pension plans. The employer will then invest the money, often in securities, to grow the funds.
Then, when an employee retires, they will receive payment from the pension plan, usually in the form of a monthly check. Several different factors determine how much money an employee gets when they retire, including how many years they worked for the company, how much they earned while working, and how old they are.
In some cases, you might need to work for a company for a certain number of years before vesting fully takes place or before you’re eligible for the pension plan. For example, an employer might contribute to a pension only for those employees who have worked for them for at least five years.
Pension plans are regulated, in part, by the Employee Retirement Income Security Act of 1974 (ERISA). This federal law provides guidelines for employers for steps they should take to protect the retirement dollars of their employees.
There are tax advantages to both the employer and employee contributions. Employers get a tax break for their contributions to a pension plan, and employees can contribute tax-free money –- The money comes out of their paycheck first, before any taxes are taken out. However, employees have to pay taxes on the money when they withdraw it from the plan during retirement.
How do you get paid from your pension?
Pension benefits are usually paid out either in one lump sum distribution or as monthly payments for the rest of your life. There are advantages and disadvantages to both options.
With the lump sum, you receive you’ll get a certain amount up front. You might be able to invest the money yourself, perhaps at a higher rate of return than your employer. And if you die shortly after you retire, you’re able to leave the money for your loved ones. The downside of a lump sum withdrawal is that the onus is on you to make sure that the money lasts for the rest of your life.
There are a couple of different ways the monthly pension payments can work. You could opt for a single-life annuity, meaning you get a monthly payment every month for the rest of your life. You could also choose a joint and survivor annuity, meaning you get a monthly payment until both you and your spouse have died. If you die first, your spouse continues to get the monthly payment. In the case of the joint and survivor annuity, the monthly payment will likely be lower because the payments are expected to last longer.
As a note, the joint and survivor annuity option is the default on pension plans when you are married. If you opt for the single-life annuity, your spouse must agree in writing to waive their right to the joint and survivor option.
The advantage of both types of monthly payment options is that you’re promised to have income for life. The downside is that it ultimately might be less money. If you and your spouse die shortly after you retire, the money is gone –- It’s not passed down to a surviving dependent or beneficiary.An employer can decide to terminate their pension plan. And it’s not at all unrealistic to think that this could happen. Over the past several decades, many companies have chosen to move away from providing pension plans to their employees.
Between 1980 and 2008, the number of private employees who had access to pension plans decreased from 38% to 20%. And as of 2018, only 17% of private employees have access to a pension plan.
Many employees over the past four decades have seen their pension plans terminated. Don’t worry, though. You’re not out the money you’ve already earned. If a company decides to terminate its pension plan, accrued benefits are frozen. You won’t be able to accumulate any more money in your pension, but when you retire, you will receive the money already there.
And if your employer does decide to terminate its pension plan, that doesn’t necessarily mean it’s eliminating a retirement plan altogether. As the number of employees with access to pension plans has decreased, the number of employees with access to defined-contribution plans like 401(k)s has increased. As of 2018, 64% of private employees had access to defined-contribution plans.
There’s also a safety net of sorts of participants in a pension plan. The Pension Benefit Guaranty Corporation (PBGC) provides some insurance for these types of plans. If your employer terminates your pension plan, the PBGC steps in and administers the plan until it's met its obligations, meaning until those who have been promised money have gotten their money. Even though the PBGC steps in, you may not receieve 100% of the pension you were promised. Often in order to keep the insurance fund solvent, in rare cases you would only receive a percentage of your promised pension.
If your employer terminates their pension plan or doesn’t offer one at all, you might be able to sign up for a 401(k) plan instead. If your employer doesn’t offer a 401(k) plan either, you’ll need to find an alternative way to save for retirement.
Many people, even those with an employer-sponsored retirement plan, choose to save for retirement by contributing to an Individual Retirement Account (IRA), which is a tax-advantaged retirement account for individuals.
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