Pensions: What Are They And How Do They Work?
Dan Miller4-minute read
November 24, 2020
Planning for retirement is one of the most important aspects of your financial future. There are many different ways to plan for retirement, and what works for some people may not work for others. One way to plan is through a pension, but pensions are not as common as they once were. In this article, we’ll take a look at what pensions are, how they work, and what role they might play in your retirement planning.
What Is A Pension?
Pensions are sponsored by and usually funded primarily by an employer as part of an overall employee compensation package. The money in the pension fund is then invested, and the investment earnings are then used to fund monthly payments for eligible holders of the pension. Pensions first became popular in the 1940s and 1950s, but their popularity has waned since then.
How Does A Pension Work?
Most pensions are primarily funded by the employer, but some plans also allow employees to contribute a portion of their income into the pension plan. In some cases, the employer will match any contributions that the employee makes. The Employee Retirement Income Security Act of 1974 (ERISA) defines minimum standards that pension plans must adhere to.
In either case, the money in the pension plan is invested in the stock market and other types of investments. With the money realized from investment gains and ongoing contributions, the pension plan typically pays out monthly payments to eligible retirees. There are many different pension plans out there, so the exact mechanism that they use to fund the plan and pay out benefits depends on the specific plan documents themselves.
Who Gets A Pension?
Most private-sector employees no longer offer pension plans today. Since Congress passed the Revenue Act of 1978, including section 401(k), the retirement plans that take their name from that section have replaced pension plans for most employees in the private sector.
There are still some public sector occupations that still offer traditional pensions:
- State and local government employees
- Utility workers
- Police officers and firefighters
- Insurance agents
Types Of Pension Plans
There are two main types of pensions: defined-benefit and defined-contribution plans. Each type of pension plan shares some similarities but is also slightly different. Knowing which type of pension plan is offered by your employer can help to inform the decisions you make about your pension benefits and retirement planning.
With a defined-benefit plan, the pension guarantees the employee a specific amount of income on retirement no matter what happens. This could be through a recurring monthly payment or a lump sum paid out at a specific age. Most traditional pensions are defined-benefit pension plans. In a defined-benefit plan, employees have no control over investment decisions, but they also have 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.
In defined-contribution plans, the employer makes a set amount of contributions, but the final benefit is dependent on the investment performance. Defined-contribution plans are typically much less expensive, which is another reason that most companies have switched to offering this type of retirement plan.
The 401(k) plan is one type of defined-contribution plan. Since their introduction in the 1980s, 401(k) plans have become one of the most popular forms of employer-sponsored retirement 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.
Pension Vs. 401(k)
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.
One common employer perk in addition to a 401(k) plan is matching on a 401(k) plan. The most way this works is for the employer to match a certain percentage of some employee contributions. One example would be an employer with a 100% match of the first 3% of employee 401(k) contributions.
Let’s say you make $5,000 a month – 3% of your monthly salary would be $150. In a case of a 100% employer match up to 3%, your employer would match, dollar for dollar, the first $150 you contributed to your 401(k) plan each month. While the exact amount that you should contribute to your employer’s 401(k) plan depends on many different factors, you should almost always contribute at least enough to max out any employer match you’re eligible for.
The Bottom Line
While pension plans are much less common than they used to be, they are still available for some professions and employers. If you are eligible for a pension plan through your employer, you’ll want to understand if it’s a defined-benefit or defined-contribution plan. That will help you know where it fits in your overall retirement plan. For even more information about all things personal finance, make sure to check out the RocketHQSM personal finance section.
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