What is a pension?
July 26, 2022 6 min read
But whatever your retirement goals, it may help to learn about the options available—like a pension—to help pay for your life after employment.
- A pension is a retirement arrangement in which employees receive a regular payment from their employer after retirement in exchange for their years of work.
- Employers usually make most or all of the contributions to a pension.
- A pension plan is also known as a defined benefit plan.
- A pension is different from a 401(k), which doesn’t guarantee payments after retirement.
What is a pension plan?
A pension plan is a guaranteed benefit that some employees may receive in retirement. It’s a retirement fund that’s paid into by an employer, employee or both throughout an employee’s years of work. But even if an employee does contribute to the pension fund, it’s usually the employer that covers at least most if not all of the money.
Employees can receive their payment in the form of an annuity, which provides fixed monthly payments. Or they may have the option to receive it in one lump sum after they’ve retired.
Types of pensions
Pensions may work a little differently depending on the type of company you work for and the type of plan it uses.
Public vs. private pensions
A public pension is managed by local, federal or state governments. And private pensions are offered through individual companies.
For example, you may have access to a public pension if you are a government employee, like a firefighter or teacher. Or you might work for a privately owned company that offers its own private pension plan.
And although pensions aren’t as common today as they once were, public pensions may still be used by federal government employees. You may also find that private companies lean more toward alternative retirement savings like 401(k)s and individual retirement accounts (IRAs).
When it comes to retirement savings, there are two common retirement plans—defined benefit plans and defined contribution plans. These are both protected by the Employee Retirement Income Security Act (ERISA). But they’re a little different from one another.
Here’s a breakdown of each type.
Defined benefit plans
A pension plan or fund is a defined benefit plan. This type of plan guarantees a set monthly payment or lump sum after retirement. It may also use a specific formula that includes how long you’ve worked at the job and your salary to determine your monthly payout.
A defined benefit plan may be funded or unfunded. A funded defined benefit plan means that your employer has set aside funds in advance and invested them in order to cover the current and future retirement payment it makes to its employees.
In unfunded benefit plans, the employer does not set aside any investments for pensions and instead pays out funds directly from its own pocket.
Example of defined denefit plan
An example of a funded defined benefit plan is Social Security, which is taken out of your paycheck during employment. Social Security is supported by the federal government and is associated with the Federal Employment Retirement System (FERS).
FERS provides retirement benefits to all federal employees. So if you’re employed by the federal government, you’re automatically enrolled in FERS, which pulls its funds from Social Security, the Thrift Savings Plan (TSP) and a Basic Benefit Plan.
And if you leave your federal government job before retirement, the Social Security and TSP portions of your plan can go with you to your next job.
Defined contribution plans
Defined contribution plans don’t guarantee a retirement benefit. The employer and employee can make contributions to these plans.
Example of defined contribution plan
A 401(k) is an example of a defined contribution plan. These types of plans may allow you to contribute a certain percentage of your pretax paycheck to your savings. And in some cases, your employer may match the percentage you’re contributing.
In defined contribution plans, the money you contribute is usually invested. Since these plans are based on investments, your balance could fluctuate.
Other defined contribution plans include 403(b) and profit-sharing plans.
Pension vs. 401(k)
The differences between traditional pension plans and 401(k) retirement plans depend on the plan type.
Pensions are defined benefit plans, where the employer usually pays for most of the plan, if not all of it. But 401(k)s are defined contribution plans funded by the employee. Sometimes employers will match their employees’ 401(k) contributions, but this isn’t always the case.
Another difference is that pensions are a guaranteed retirement benefit employees will receive after retirement. A 401(k) isn’t a guaranteed payout, and the employee has to decide whether to enroll in it.
Realities of a pension
To receive a pension, you generally have to be vested in your company. This means that you have to work for your employer for a certain number of years. And depending on your employer, it could take around 5 or 7 years to become fully vested.
But if you work for more than one company, it’s possible to collect multiple pension payments—assuming you worked for each company long enough to be vested.
Besides the number of years you worked for an employer, your pension payments may also depend on your work history, salary amount and age.
According to Experian, “you typically can’t obtain full benefits until you reach a certain age, like 62 or 65. But if you retire early—at age 55 or 60, for example—you may be able to receive a lower monthly pension payment. And if you’re terminated by your employer, you still may qualify for a reduced pension payment, depending on your age.”
Pros and cons of pensions
Here are some pros and cons of pensions:
- Pensions can provide guaranteed income during retirement.
- A pension can help contribute to your financial well-being after retirement.
- In most cases, the employer is responsible for managing the full pension—or at least the majority of it.
- Your pension could be underfunded. This could mean you don’t get paid what you were promised.
- You must work for your employer for a certain amount of time to be eligible.
- Pension payouts can be subject to taxes.
- Fewer and fewer employers are offering pensions today.
Alternative retirement plans
- 401(k) retirement plans
- Individual retirement accounts (IRAs)
- SIMPLE 401(k) or IRA plans
- 403(b) retirement plans
- Roth 401(k) plans or IRAs
- Employee stock ownership plans
- Profit-sharing or stock bonus plans
- Government plans
- 457 plans
- Multiple employer plans
To decide what plan works best for your retirement goals, it may help to research the plans you’re interested in and find out whether they can help meet your needs.
Pensions in a nutshell
Pensions can be a valuable benefit that offers guaranteed income during retirement. But it’s important to understand the exact terms of your pension plan to know if it can realistically cover your retirement needs—or if you will need to supplement your pension with additional help.
And whether your company offers pensions or not, you can always create your own retirement fund with a little strategy and planning. You’re only a click away from learning more ways to save for retirement.