How do pensions work?

Pensions are retirement plans that provide income for employees after they retire. Employers, employees or both may contribute depending on the specifics of the pension.

Pensions have become much less common in the private sector despite their appeal to employees. However, the vast majority of public sector employees still have access to pensions. We’ll break down the specifics of pension plans and how they work.

What is a pension?

The term “pension” typically refers to a defined-benefit plan. Pensions have a long history in the United States, as the first employer-provided pension plan was from the American Express Company in 1875. By 1987, there were more than 232,000 private pension plans covering about 40 million employees.

Although defined-benefit plans are often quite popular with employees, they can be costly to set up and maintain. This has caused another type of retirement plan, the defined-contribution plan, to grow in popularity. Defined-contribution plans include retirement plans such as the 401(k) and plans for employees of nonprofits, such as the 403(b).

While many private-sector employers have switched to defined-contribution plans, most public-sector employees still have access to defined-benefit plans. By some estimates, around 80 percent of public sector employees participate in these plans.

Understanding how pensions work

Employers offering defined-benefit plans regularly contribute money to a fund for employees. The money is invested, allowing it to grow over time. When eligible employees retire, they receive regular fixed payments generally for life, like an annuity. This amount is not dependent on investment performance.

Pension can also refer to a defined-contribution plan, such as a 401(k) or 403(b). Employees regularly contribute to these plans, often via payroll deductions. Employers may provide matching contributions up to a percentage of compensation or a flat dollar amount. However, with a defined-contribution plan, the onus is no longer entirely on the employer to contribute.

Regardless of the retirement plan, these funds provide income to eligible employees and have tax advantages, incentivizing employers and employees to invest.

Also like other retirement plans, pensions have vesting schedules, where you gradually gain ownership in the account. There are two types: cliff vesting and graded vesting.

Cliff vesting schedule

A cliff vesting schedule takes an all-or-nothing approach. If you leave your job before fully vested, you won’t receive any of your pension benefits. But if you wait until you are fully vested, you will receive the full amount of your pension. A cliff vesting schedule usually ranges from one to five years.

In some cases, losing out on retirement benefits can mean foregoing a significant amount of money. A pension calculator can help you estimate how much you will receive.

Graded vesting schedule

Graded vesting allows you to be eligible for some of your retirement benefits even if you leave your job before being fully vested. You might be eligible for a higher percentage of your full retirement benefit for every year or two of service.

To give a simple example, if you have a six-year graded vesting schedule, you might receive 0 percent after the first year, 20 percent after the second year, 40 percent after the third year, etc. After six years, you would be 100 percent vested.

Graded vesting schedules vary by employer. Employees who leave their jobs prior to retirement may sometimes receive a lump sum upon their departure. In other cases, it may be necessary to wait until retirement to receive the funds, either as monthly payments or a lump sum (which can be invested in an annuity for guaranteed income). Penalties may apply if taking a lump sum prior to retirement.

Types of pension plans

The two most widely known types of pension plans are defined-benefit and defined-contribution plans. However, government pensions also have distinct features that are worth discussing.

Defined-benefit pension plan

Employees with defined-benefit plans receive monthly payments for life or a lump sum when they retire. The employer commonly provides most of the funding. If the employee opts for monthly payments, the amount is generally guaranteed.

If the pension plan cannot cover the full amount, the employer must make up the difference. This can create a costly burden for employers, especially if the fund’s investments don’t perform as expected.

Defined-contribution pension plan

Defined-contribution plans include 401(k), 403(b), and 457(b) plans. There are several types of defined-contribution plans because they vary based on the type of employer. However, employees provide much of the funding for these plans. Employers often provide matching contributions for these plans up to a percentage of compensation or a set dollar amount.

Employees can begin taking distributions from a defined-contribution without penalties after age 59½. Employees aren’t required to withdraw a certain amount from these plans, but required minimum distribution (RMD) rules apply. These plans are often favorable for employers since employees withdraw money from their accounts rather than employers paying retirees a guaranteed amount every month.

Government pensions

Government pensions are similar in many ways to private-sector pensions. However, while private employers often provide all the funding for defined-benefit plans, government employees may contribute to their defined-benefit plans along with their employers.

Another difference with government pensions is that they may include plans like the Thrift Savings Plan (TSP). These plans are defined-contribution plans, but matching contributions may be more generous than private-sector equivalents.

Advantages of pensions

There are several possible advantages of pensions, making them attractive to employees.

• Guaranteed income: Perhaps the biggest benefit is that pensions provide guaranteed income to employees opting for monthly payments. This simplifies retirement planning and supplements Social Security, which is often insufficient to cover basic needs.
• Employer funded: Another big benefit is that pensions tend to be funded entirely by the employer. This allows employees to increase their retirement compensation without reducing their paychecks. If employees do contribute, they typically get a tax break.
• Some investment control: With defined-contribution plans, employees may have some control over their investment selections, allowing them to weigh their risk tolerance and time horizon.
• COLA: Some pensions provide cost of living adjustments (COLA), which can be a highly valuable benefit for employees, especially if they have a lengthy retirement.

Risks of pensions

Although pensions have many benefits for employees, they aren’t entirely risk-free.

• Employer dependence: If the employer has financial struggles or goes bankrupt, the pension fund could default. Some protections exist for these situations, but you may not always get the full amount.
• No individual control: As an employee you  have little to no control over how pension funds are invested. Unlike defined-contribution plans, you can’t take advantage of a strong market and higher returns. Even if the market performs extremely well, you’ll receive the same benefit. On the flip side, your income is guaranteed regardless of market conditions.
• Value may shrink: If the plan doesn’t provide COLAs, the value of your income will decrease with time.

Bottom line

With the traditional pension plan, known as a defined-benefit plan, employers set aside funds in a pool of money that is invested. Employees who retire receive either a lump sum or guaranteed set monthly payments for life, regardless of investment performance.

Defined-contribution plans such as a 401(k) or 403(b) invest money from employees and matching contributions from employers if applicable. Employees pick their investments and receive retirement income based on how much they’ve saved and how well their investments have grown. Both types of pension plans have pros and cons, but each can supplement Social Security payments.