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What Is a Pension Plan?

A pension plan is a form of Defined Benefit (DB) retirement plan. A company may provide a pension plan to its employees. These pensions provide a set level of income in retirement, though this assumes the company doesn’t fold or confiscate pension funds in the future. While defined contribution plans like 401(k)s have largely replaced pensions for most Americans working in the private sector, many workers still have pensions coming their way in retirement. If you have questions about pensions or anything else that has to do with retirement, consult with a financial advisor in your area.

What Is a Pension Plan?

In a pension plan, an employer sets aside money for an employee and invests that money on the employee’s behalf. The proceeds then become income for the retired employee, either in a lump sum or in regular payments through an annuity. Depending on the plan, those pension benefits may be inheritable by a surviving spouse or children.

Your pension income is usually paid out as a percentage of your salary during your working years. That percentage depends on the terms set by your employer and your time with the employer. A worker with decades of tenure with a company or government may be entitled to 85% of their salary in retirement. One with less time under their belt, or at a less generous employer, may only receive 50%.

Employees with these plans don’t participate in the management of those funds. This is both a benefit and a disadvantage. You don’t have to worry about choosing the right investments for your pension, but you’re also vulnerable to any investing mistakes your employer might make.

If you leave your employer before your pension benefits “vest,” you won’t have access to the money your company put aside for you when you go. Vesting schedules come in two forms: cliff and graded. With cliff vesting, you have no claim to any company contributions until a certain deadline – say, four years. With graded vesting, a certain percentage of your benefits vest each year, until you reach 100% vesting. So, if you leave a company after a year, you might leave with nothing, or you might leave with just 25% of your pension available to you. If you don’t know the vesting schedule for your benefits, it’s a good idea to find out. It would be a shame to leave your job a week before your benefits vest, wouldn’t it?

Pensions vs. 401(k)s

What Is a Pension Plan?

In the private sector, the 401(k) has largely replaced the traditional pension. A 401(k) is a defined contribution plan, which means the only thing you can count on is the money that you put into your 401(k) – your contribution – and the money it earns in the market. By contrast, a defined benefit plan clearly specifies the money you’ll receive in retirement – your benefit.

Both pensions and 401(k)s enjoy tax-deferred growth, however. Some 401(k)s come with employer matches, in which your employer will match any contribution you make up to a set limit. With a 401(k), your employer will give you a menu of options from which you’ll choose how to invest your contributions. This allows you to be more in control.

Because your pension income grows tax-deferred during your working years, you pay taxes on it when you start getting checks in retirement.

Pensions and Social Security

People who have pensions from a government employer may not be eligible to receive Social Security benefits, or they may receive only partial benefits. This is because some public-sector workers who have pensions to look forward to aren’t subject to Social Security payroll taxes. Because they don’t pay into the fund, they don’t receive full benefits. If you worked part of your career in the private sector but also spent part of your career in a public-sector job with a pension, brace yourself for the Social Security Windfall Elimination Provision (WEP).

The WEP limits Social Security benefits for people who also have pension income coming their way. There’s also the Government Pension Offset (GPO), which limits the spousal or survivor benefits available to people who have government pension income.

Why do the WEP and the GPO exist? Believe it or not, the purpose is to make Social Security benefits more fair. Social Security benefits are calculated on a person’s 35 years of highest-earning work. If any of the 35 years were spent in a public-sector job not subject to Social Security payroll taxes, the person gets a score of “0” for those years – just like an unemployed person would.

But if you had a well-paying government job, you have other benefits to count on. For this reason, Congress decided you could do without some Social Security benefits, on the assumption that your government pension was already providing you with retirement income from government coffers. Plus, the GPO and WEP save Social Security money, always a big concern in Washington. Regardless of how you feel about the GPO and WEP, it’s important to be aware of how the two provisions can affect your Social Security benefits – and plan accordingly.

Public vs. Private Pensions

What Is a Pension Plan?

The difference between a public pension and a private pension is simple enough to understand. Public pensions are available through governments on federal, state and local levels. Police officers and firefighters likely have pensions, for instance.

Some private companies also offer pensions. This variety of pension is increasingly rare, as more companies opt instead for the 401(k) plan.

Another difference that could be troubling to government workers is that private pension funds have more legal protection than public pension funds. This essentially means that private companies have a legal obligation to make sure their pension funds have adequate funding, but public pensions aren’t subject to the same requirements. Because of this lack of legal protection, many state pension funds are seriously underfunded, which could result in a drastic reduction of benefits if nothing changes.

Risks With Pension Plans

Although having access to a pension has many benefits, no retirement plan is without risks. Unlike with a 401(k) plan or IRA, you have no say in how your company invests the pension fund. If the manager of your pension fund makes bad investment decisions, that could potentially result in insufficient funds. This could mean a reduction of your benefit without warning.

Another risk of not being in control is that your company could change the terms of your pension plan and decrease the percentage of salary for each recipient. Seeing as pensions are much more expensive for employers than most alternatives, it’s in your employer’s interest to minimize costs. In the case of public pensions, there’s also the risk that the state or municipality will encounter economic issues and declare bankruptcy, which could result in a reduction of benefits for pension-plan participants.

For these reasons, it’s best to save on your own as a supplement to your pension. You don’t want to count on having a lavish pension and then be unexpectedly short on funds.

Bottom Line

In today’s retirement landscape that’s dominated by defined contribution plans, it’s easy to feel nostalgic for the pension. Wouldn’t it be nice to have an account that someone else is worrying about for you?

It’s worth remembering, though, that pensions were by no means universal in the past. And, they’re unlikely to gain ground again. Plus, these plans aren’t infallible. Your company might freeze your plan, or scale back benefits so that employees get a smaller percentage of their salary in retirement. They might make bad investment decisions that wipe out the pension fund. They might even announce a switch to a cash balance plan. In other words, having a pension isn’t a guarantee of a wealthy retirement. All the more reason to save on your own, starting as soon as you can.

Tips for Preparing for Retirement

  • Work with a financial advisor to make sure you’re on pace for a comfortable retirement. Luckily, finding the right financial advisor for you out doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Figure out how much you’ll need to save in order to retire comfortably. An easy way to get ahead on saving for retirement is by taking advantage of employer 401(k) matching.

Photo credit: flickr, ©iStock.com/DNY59, ©iStock.com/vgajic

Amelia Josephson Amelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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