What Is a Pension & How Does It Work?

  • A pension is an employer-sponsored retirement plan that guarantees a source of income during retirement.
  • Pensions have become less common among private companies in favor of 401(k) plans, which are less costly for employers to maintain.
  • The main difference between a traditional pension and a 401(k) is that 401(k)s don’t actually guarantee any retirement benefits

Retirement is an anxiety-inducing topic for many. In the US 50% of women and 47% of men between ages 55 to 65 have no retirement savings, a 2017 Census survey found.

Retirement planning is represented using the three-legged stool metaphor, with each “leg” representing social security, personal savings, and pensions. “So the idea is that if you have all three of those, you’re setting yourself up for a good future,” says Chad Parks, founder and chief executive officer of Ubiquity Retirement + Savings and executive producer of the documentary “Broken Eggs: The Looming Retirement Crisis in America.”

But over time, the retirement stool is leaning heavily toward the personal savings “leg” as increasingly important since social security isn’t enough to entirely support retirees — and pension plans are becoming increasingly scarce as 401(k)s have become the dominant form of employer-sponsored retirement plans.

What is a pension?

Pensions are a type of retirement plan where the employer deposits money into it during the employee’s time at a company. The amount is calculated based on the employee’s salary history and length at the company. Later when the employee retires, the pension offers a guaranteed monthly source of income until they pass away.

Some especially generous — and especially rare — pensions even offer survivor benefits, which provide the surviving spouse with a percent of the pension money owed to the employee.

The type of retirement plan available to you depends on your employer. Many state and local government jobs, such as teachers, still offer traditional pensions. However, 401(k)s are quickly taking over as the dominant retirement plan for private companies, though traditional pensions are one of several terms that labor unions may fight for in negotiations.

“You’re probably not going to get [a pension] at a private corporation, or even a publicly traded company,” Parks says. “It’s very hard to find that kind of generosity today.”

How do pensions work?

The value of a traditional pension is accrued throughout the employee’s time working for an employer, “so the longer you work, the bigger your payoff is going to be,” Parks says. The value of a pension also takes the employee’s pay into consideration as well as the expected growth rate of the company.

Once an employee works at a company long enough, they become vested in their pension, which means they are guaranteed the money in their pension regardless of their position at the company — even if they get fired or move companies. Vesting is a gradual process, so if you work a few years at a company, you can become partially vested in a pension.

Pensions are usually either unfunded or funded: which indicates how a company is planning to pay for the pension. Money from a funded pension comes out of a pool of invested money that the employer sets aside specifically for pensions. Meanwhile, unfunded pensions are paid out directly from the company. Entities with unfunded pensions are acknowledging that at some point they have to gather the funds to pay for the pension, but they don’t currently have it on hand.

Parks says that pensions were originally paid for entirely by the employer. However, most modern pension plans incorporate some method for the employee to contribute to the pension “either in their own defined-contribution to match and augment the pension or, in some cases, they’re going to be taking a haircut on their paycheck to help fund it,” Parks says.

Are pensions taxable?

Pensions are generally taxable as ordinary income in whatever

tax bracket

you land in post-retirement. “There’s this joke that everybody retired and moved to Florida. Well, there’s a reason why, right? It’s the weather plus there’s no

income tax

,” Parks says.

Pension vs. 401(k)

Here’s the main difference between pensions and 401(k)s: a 401(k) is a defined-contribution plan where both employer and employee can contribute to the account and invest funds to save for retirement. A pension is a defined-benefit plan that’s sponsored by the employer that offers benefits based on salary and employment history at the company. So essentially pensions are plans where the employers are set up with higher costs and investment risks.

Because pensions are mainly paid for by the employer, 401(k)s became very appealing to companies that want to provide retirement benefits without incurring a steep cost. “Corporate America had a big shift in the ’80s, to say, ‘let’s get out of the pension business, but we have to replace it with something.” So that’s when the 401(k) became popular,” Parks says.

The 401(k) is one of several defined-contribution plans, which also includes 403(b) plans, employee stock ownership plansand profit-sharing plans. These plans have employees shave off some of their pre-tax income and put it into an investment account. Employers can match an employee’s contribution up to a certain amount.

Unlike a defined-benefit plan, nothing is particularly guaranteed in a defined-contribution plan because it’s all up to the employee to save for retirement. Instead of a guaranteed retirement payout, an employee’s retirement fund is determined by the market and the success of the investments. “‘Defined’ doesn’t really fit here. So it’s kind of a misnomer,” Parks says.

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