What Is a Pension Plan and How Does It Work?

retirement plan and pension plan folders on desk
©Shutterstock.com

A pension plan, by definition, is a retirement plan offered by employers. It provides monthly income to retirees. For some, it supplements Social Security, while for others, a pension replaces it. Unlike a 401(k) or an individual retirement account, a pension is funded by the employer.

Pension funds pool together pension plan contributions and invest them. The earnings from these investments later become retirement income for the employees.

What Is a Pension Plan?

When employers offer pension plans as a benefit to their employees, they agree to set aside money for each employee. This money grows over time and eventually provides a guaranteed benefit for the employees during retirement.

Not all employers offer pension plans. Many private employers do not provide them, but most government organizations do.

In most cases, pension plan funding comes from the employer and not the employee. Pension plans typically do not require the employee to manage the funds, and some are even voluntary. There are exceptions to this rule, so you should check your employer’s terms.

What Is a Pension Plan Value?

The pension plan value is the amount of money available in the pension account. This amount can fluctuate with changes in the value of the account’s investments.

How a Pension Plan Works

Pension plans are similar to other types of retirement plans. Money is set aside and invested. That investment pays a benefit for retired workers.

Formula

Pension eligibility and income are typically determined by a formula. This formula factors in the following:

Are You Retirement Ready?
Sponsors of
  • Years of service: Plans may require employees to work for the company a certain number of years to receive full benefits.
  • Salary: Some plans use an average of the three highest-salary years or the three final salary years.
  • Multiplier: A percentage used to calculate the benefit amount

Example

Consider an employee who worked for 30 years at Company X. The employee’s three highest annual salaries have an average of $100,000. If the plan has a multiplier of 2%, the employee’s benefit would be $60,000 per year.

(30 x $100,000) x 0.02 = $60,000

Plans may require employees to reach a certain age before receiving a benefit.

Government Regulations

The Department of Labor sets rules that govern pension plans. It enforces the rules outlined in the Employee Retirement Income Security Act, which applies to most private pensions.

Schedule

Vesting is another word for ownership of a pension plan. Employers use this as an incentive to encourage employees to keep working at the company. The longer they work, the greater their vestment in the retirement plan.

There are two types of vesting:

  • Cliff vesting: Employees are 100% vested after a certain date. This may occur, for example, after two years of successful performance.
  • Graded vesting: Employees receive a percentage of vestment after each year of service. It could be 20% each year, for example.

Taxes

Most pension income is taxable. You may have to pay federal and state income taxes when you receive disbursements.

The exceptions to this rule are:

  • After-tax money contributions to pensions
  • Some military and government pensions due to disability

Types of Pension Plans

Pension plans can be categorized either by “employer” or “contribution.”

Employer

Both public and private employers offer pension plans. Federal, state and local governments may offer pensions to employees. This includes teachers and firefighters.

Pension plans offered by private employers have legal protection to ensure adequate funding. Fund contributions must be insured by the Pension Benefit Guaranty Corp. Many of these plans are being replaced by other options, and new employees may not be eligible for their employer’s pensions.

Contribution

When considering retirement savings options, most workers want to know what is the benefit of a pension plan. One answer to this question is the way funds are contributed to the plan.

Defined benefit plans provide a guaranteed amount of money regardless of investment returns. These plans may use a formula to calculate the amount of the benefit during retirement.

Defined contribution plans allow employers and/or employees to contribute money to the fund while the employees are working. The benefit amount they receive during retirement depends on the investment returns.

What Is a Qualified Pension Plan?

A qualified pension plan is one that meets form and operation standards determined by the IRS. In qualified plans, the employee’s contributions are tax-deferred. Employers are allowed to deduct their contributions to the plan.

Qualified plans must:

  • Give disclosures about the plan to participants upon request
  • Provide coverage for the required employees
  • Allow full participation to employees who meet eligibility requirements
  • Allow vesting
  • Treat high-earning and lower-earning employees equitably

Pension Plan Risks

All investments carry a degree of risk, and pension plans are no exception. The primary risks of pension plans include:

  • Choice: Employees have no control over how pension funds are invested.
  • Bankruptcy: If the company files bankruptcy, employees’ pensions are generally safe, but the Pension Benefit Guaranty Corp. may need to step in.
  • Mismanagement: Poorly managed plans can lead to a reduction of benefits for employees.
  • Termination: The employer can terminate a pension plan.

Pension Plan vs. 401(k)

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. Here are other differences between the two plans:

Pension Plan:

  • The employer decides how much it will contribute and how those contributions will be invested.
  • If you leave the company, you might only get part — or none — of your pension.

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.

Is a 401(k) or Pension Plan Better?

Both 401(k)s and pensions have their merits. Pensions promise an income for the duration of your retirement, while you may outlive your 401(k).

On the other hand, you have more control over how your 401(k) is invested. If your employer matches your 401(k) contributions, you can maximize your savings. Ultimately, the right choice for you is the one that best helps you meet your financial goals.

Pension Plan Alternatives

Pension plans were once a staple of American employee benefits. In 1980, employer-based retirement plans comprised 92% of all private retirement savings. By 2019, only 21% of workers participated in a pension plan.

Many companies stopped offering pension benefit plans because they were expensive to maintain. If you work for a company that doesn’t offer a pension, you need an alternative. Here are other ways to save money for your retirement — and they have some advantages over a pension.

401(k)

A 401(k) plan is an employer-sponsored plan that lets you contribute pretax 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.

Individual Retirement Account

Individual retirement accounts are more commonly known as IRAs. They are savings accounts with tax advantages. With an IRA, you have a choice of how to invest funds and can contribute even if you have a pension plan.

There are several types of IRAs, including the following:

  • Roth IRA: A Roth IRA lets you contribute money you have already paid taxes on. When you withdraw the money in retirement, you don’t have to pay any income taxes on the money.
  • Traditional IRA: A traditional IRA lets you contribute pretax 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.

Key Takeaways on Pension Plans

The benefit of a pension plan is the guaranteed income it provides during retirement. Although it is controlled by the employer, the plan’s benefit is essentially free money to the worker. This is in contrast to 401(k) plans and IRAs that are funded by the employee.

If your employer offers a pension plan, research how the plan works and the benefits it provides.

This article has been updated with additional reporting since its original publication.

    Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.

    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.