What Is a Pension Plan and How Do They Really Work?

Learn how to make the most of this retirement plan type.

If you have a pension plan through your employer or are considering taking a job that offers one, it’s important to understand how they work. A pension provides income to retirees. It might supplement Social Security, or it might replace it, in the case of some government employees. Unlike a 401(k) or IRA, a pension is funded by the employer.

Pension plans were once a staple of American employee benefits — according to the Employee Benefit Research Institute, 46% of private sector workers in the U.S. were covered by a pension plan in 1980. By 2006, this number had dropped to 20%. Employer-funded pensions have largely been replaced by employee-funded 401(k) plans.

A pension plan might be offered by a private employer, such as a corporation, or by a public employer, like a government agency. Public employers are more likely than private ones to offer pensions. According to the Bureau of Labor Statistics, 75% of state and local government workers participated in a defined benefit pension plan in 2016.

In this guide, learn what you need to know about pension plans and how they compare with other retirement plans:

What Is a Pension Plan and How Does It Work?

A traditional pension plan is sometimes called a defined benefit plan. It’s a retirement account that is sponsored and funded by an employer for their employees, and it’s designed to replace a percentage of the employee’s income once they retire.

It’s called a defined benefit plan because the benefit, or the amount of money you will receive, is a predefined number based on your salary at retirement, your age and the number of years you worked at the company. Once you retire, you will continue to collect a pension check every month.

Advantages and Disadvantages of Pensions

Pension plans are advantageous to workers for two main reasons. First, the employer, not the employee, makes the contributions to the plan. But a job with a pension might pay less than a job without one for this very reason. Second, a defined benefit pension pays out for the employee’s lifetime, so you don’t have to worry about outliving your money.

The disadvantage to a pension is that it’s dependent on your employer’s ability to pay it. If a company goes bankrupt, it might not be able to pay its pension obligations, and those employees who were depending on that pension might have no other retirement savings.

Types of Pension Payouts

Pensions can be paid in two different ways: A lump sum or an annuity. A lump sum payment is a single payment you get when you walk out the door on your last day of work. It’s up to you to decide how to invest and spend that money so it lasts the rest of your life.

An annuity is a series of periodic payments. If your pension is an annuity, you will collect a certain amount every month until you die. If your pension is $1,000 a month, and you die a month after you retire, you’ll have collected a total of $1,000 from your pension. If you live for 20 years after you retire, you’ll have collected $240,000 from your pension.

Some pensions offer a spousal benefit for a surviving spouse. If you select this option, your spouse might get a percentage of your pension after you die.

Consider: Companies That Still Offer Pensions

How Taxes Affect Pension Plans

If your employer made the contributions to your pension plan, as is usually the case, then your payments will be taxable. You can arrange to have taxes withheld from your pension check like you do from your paycheck.

Pension Vesting

Pensions are a way of encouraging employees to stay at the company for many years. For this reason, employees’ pension benefits vest over a period of years. If you’re 100% vested, it means you own all of your plan and will receive your full pension when you retire. If you leave the company after just two years, for example, you might be only 40% vested and so will receive 40% of your pension amount.

There are two kinds of vesting:

  • Cliff vesting: With cliff vesting, your plan vests all at once, but only after a certain number of years. So you might have no vesting for the first two years at the company, but after three years you’re 100% vested.
  • Graded vesting: Graded vesting means that you’re vested a certain percentage per year until you reach 100%. A common graded vesting schedule is to vest 20% after two years, 40% after three years, and so on, until you are 100% vested after six years with the company.

Check Out: Best and Worst States for Pensions

Pension Plan vs. 401(k): Is One Better Than the Other?

The biggest difference between a 401(k) and a pension is that the 401(k) is funded by the employee and the pension is funded by the employer. With a 401(k) plan, the employee decides whether or not to contribute, how much to contribute and how to invest those contributions. If you leave the company, you take all of your 401(k) contributions with you.

With a pension, your employer decides how much they will contribute and how those contributions will be invested. If you leave the company, you might only get part of your pension.

To answer the question, “Is a pension better than a 401(k)?” ask yourself what kind of saver and investor you are. If you know you’ll contribute the maximum amount possible to your 401(k) and will invest it wisely, and you think you might change jobs a time or two before retirement, you might find a 401(k) has the flexibility you want. If you know you don’t save or invest conscientiously, and you think you’ll retire from your current company, you might want the pension.

Will a Pension Affect Social Security?

If you have a pension and have paid into Social Security, your pension might reduce the amount you collect from Social Security. Here’s why: Lower-wage workers get a higher percentage of their pre-retirement income in the form of Social Security after they retire. If you worked at a job where you paid into Social Security and then worked at a job when you didn’t pay into Social Security because you have a pension, you would qualify based on lower average earnings than you actually had. So the government came up with the Windfall Elimination Provision, which can reduce your Social Security benefit based on the number of years of substantial earnings you had.

Alternatives to Pension Plans

If you don’t have a pension plan, there are other ways to save money for your retirement, and they have some advantages over a pension.

  • A 401(k) plan is an employer-sponsored plan that lets you contribute pre-tax money into an account you control. In some cases, your employer might match some or all of your contribution, essentially giving you “free money” to save for retirement. A 401(k) plan gives you more flexibility than a pension.
  • A Roth IRA lets you contribute money you have already paid taxes on, so when you withdraw the money in retirement, you don’t have to pay any income taxes on the money you put in or the money you earned on your investments.
  • An IRA lets you contribute pre-tax money for retirement. You’ll pay the taxes when you take it out, but you might be in a lower tax bracket after you’re retired.

How To Maximize a Pension Plan

One of the major features of a pension plan is the survivor benefit. A pension recipient can choose to receive 100% of their pension amount for their lifetime. Or, they can elect a smaller amount for their lifetime, with the benefit continuing for their spouse if the spouse outlives the pensioner.

“Survivor benefits within a pension are an incredibly powerful financial planning tool, especially when there is a high probability that the spouse will outlive the pensioner by an extended period of time,” said Greg Klingler, CFP and director of GEBA Wealth Management. “This is likely to happen if a spouse is in substantially better health or is substantially younger than the pensioner. However, this tool can be an expensive one, reducing the pension by upwards of 10% for what can be the life of the pensioner — I have seen a reduction that would equate to a total of more than $300K over a 30 year period.”

“The weakness of most survivor benefits is when there is not a high chance that the pension will benefit the survivor for a lengthy period of time,” said Klingler. “In the case that the spouse passes away around the same time or before the pensioner, all of the reductions in pensions are lost. It is in situations like this where people in good health can benefit from purchasing life insurance instead of signing up for a survivor benefit because the beneficiary of life insurance can be changed at any time — all your hard-earned money will go to someone that you care about.”

See: Jobs That Still Come With a Pension

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About the Author

Karen Doyle is a personal finance writer with over 20 years’ experience writing about investments, money management and financial planning. Her work has appeared on numerous news and finance
websites including GOBankingRates, Yahoo! Finance, MSN, USA Today, CNBC, Equifax.com, and more.