Pensions: What Are They And How Do They Work?

Securing your financial future and planning for retirement is a paramount concern for everyone. As you consider the various avenues that can be taken when planning for retirement, a pension is a key element to consider. We’ll explore the world of pensions, shedding light on their operation and importance in the broader landscape of retirement planning.

What Is A Pension?

How Do Pension Plans Work?

Pensions are commonly funded primarily by employers, though some plans permit employee contributions, sometimes matched by the employer. The Employee Retirement Income Security Act of 1974 (ERISA) sets essential standards for pension plans. These funds are typically invested in various financial markets, generating returns that, combined with ongoing contributions, fund regular monthly payments for eligible retirees. The specifics of each pension plan's funding and benefit distribution methods are outlined in the plan documents and can vary significantly.

Pension Plan Types

Pension plans come in different styles and are not one-size-fits-all. When comparing these plans, keep in mind that they vary in terms of benefits, investment responsibility, and popularity, with the following chart providing more detailed insights.

How Defined-Benefit Plans Work

Defined-benefit plans guarantee the employee a specific amount of income on retirement no matter what. This pre-established amount is calculated by carefully considering the employee’s salary and years of service to the employer. The approved amount can be distributed either by monthly payments or a lump sum paid out at a specific age. In a defined-benefit plan, employees have no control over investment decisions, but they also assume no risk.

Defined-benefit pension plans are often guaranteed by the Pension Benefit Guaranty Corporation. If the investment income or contributions are not sufficient to meet the required monthly payouts, the company is required to make additional contributions in order to make the pension whole. This extra risk is one reason many companies in the private sector have moved away from defined-benefit pension plans.

How Defined-Contribution Plans Work

Defined-contribution plans don’t promise employees a fixed amount of benefits at the time of their retirement, and the final benefits are heavily dependent on the investment performance. Defined-contribution plans involve contributions made by the employee, employer, or both, typically at a fixed rate, like 5% of earnings annually. These contributions are usually invested on behalf of the employee, leading to a balance in their account. The account's value fluctuates based on contributions and investment gains or losses.

Examples of such plans include 401(k), 403(b), employee stock ownership, and profit-sharing plans. With a 401(k), while the employer may make some contributions, most come from the employee, and the investment choices are also typically controlled by the employee. This means the employee, not the employer, carries almost all of the investment risk.

Is A 401(k) A Pension Plan?

A 401(k) is a type of defined-contribution plan widely used nationwide since the 1980’s. While often grouped together with other defined-contribution plans, the 401(k), has some unique characteristics that differentiate it from other pension plans. While a pension and 401(k) are both employer-sponsored retirement plans, a pension is fully funded by the employer and guarantees a set monthly retirement income, while the 401(k) shifts the burden and risk of saving and investing for retirement onto the employees.

• Investing and saving are the employee’s responsibility.
• Employees are at liberty to choose the portion of their paycheck to contribute.
• Employers agree to match a certain percentage of biweekly or monthly investments.
• In contrast, other pension plans are fully funded by the employer.
• Contributions made by the employee are tax-deferred, lowering their taxable income.

Pension Plan FAQs

The following are answers to frequently asked questions regarding pension plans.

How much do pension plans usually pay?

The amount that a pension plan pays out can vary quite widely depending on factors including (but not limited to) years of employment, salary history, and the specific terms of the pension plan. Some plans aim to replace a certain percentage of an employee's retirement income, typically around 70% – 85%. Government pensions, like Social Security in the U.S., have their own formulas and maximum benefit limits, while private pension plans can differ considerably in their payouts.

Will I lose my pension if I quit my job?

Every employer is different and will have different conditions regarding what happens to your pension if you quit or get fired from your job. In some instances, if you leave your job before you’re fully vested (have ownership) in your pension plan, you may forfeit some, or maybe even all of your accrued pension benefits. Some pension plans offer options for deferred vested benefits, allowing you to receive your retirement benefits at a later date.

How do pension plans pay out?

Pension payments often pay in regular monthly installments to retired individuals. How the money is given to the retiree is dependent on their specific pension plan. Some offer a lump sum option, where retirees receive the entirety of their benefits in a one-time payment.

How many years does a pension plan last?

Every pension has different terms and caters to different employees’ needs. Some pension plans provide financial assistance for the rest of the retiree’s life, while others may have a fixed number of years for which payments are guaranteed. It’s essential to refer to the plan’s details to determine how long a pension will last in a particular case.

The Bottom Line

Pensions come in various forms, including defined-benefit and defined-contribution plans, each with its unique advantages and considerations. Your choice should align with your financial goals and risk tolerance. To make the most of your retirement planning, it's essential to explore all your options and ensure your investments grow steadily over time. Consider signing up for the Rocket Money^SM app as a tool to help you manage your savings and investments.