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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 pensions to its employees. These pensions provide a set level of income in retirement – assuming the company doesn’t fold or confiscate pension funds. The Defined Contribution (DC) plan has largely replaced the pension for most American workers. Let us explain how pensions work.

Check out our retirement calculator.

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.

How much pension income you get depends on the terms set by your employer, your salary and your time with the company. For example, some workers’ pensions entitle them to 85% of their salary in retirement.

Employees with pensions don’t participate in the management of their pension 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 (remember Bernie Madoff?).

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’re not entitled to any company contributions until a certain deadline, say four years. With graded vesting, a certain percentage of your benefits vest each year, until 100% vesting. So, if you leave a company after a year, you might leave with nothing – or with 25% of your pension still 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. Unlike a Defined Benefit plan such as a pension, with a 401(k) the only thing you can count on is the money that goes out of your paycheck and into your 401(k) (your contribution), not 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, which makes them a little more pension-like. With a 401(k), your employer will give you a menu of options from which you’ll choose how to invest your contributions.

Check out our 401(k) calculator.

Is Pension Income Taxable? 

Yup. Because your pension income grows tax-deferred during your working years, you pay taxes on it when you start getting checks in retirement. You didn’t expect to dodge the Tax Man forever, did you?

Related Article: Is Your Pension Safe?

Pensions and Social Security

What Is a Pension Plan?

People who have pensions may not be eligible to receive Social Security benefits, or may receive only partial benefits. Public-sector workers whose earnings aren’t subject to Social Security payroll taxes don’t accrue credits for Social Security. 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 is designed to limit 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, they were designed 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 and you weren’t unemployed for those years, 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.

Bottom Line

In today’s retirement landscape, dominated by Defined Contribution plans, it’s easy to feel nostalgic for the pension. Wouldn’t it be nice, folks say, to have a pension that someone else was worrying about, rather than having to allocate our own retirement savings?

It’s worth remembering, though, that pensions were by no means universal in the past, and they’re unlikely to gain ground again. Plus, pension plans aren’t infallible. Your company might freeze your pension 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, or they might announce a switch from a pension plan 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.

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

Amelia Josephson Amelia Josephson is a staff writer covering financial literacy topics at SmartAsset. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.

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