What are pension plans?
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Pension plans, once a staple of retirement planning, have become less common as more companies transition to defined contribution plans like 401(k)s. Despite this trend, traditional pension plans remain one of the best retirement plans out there.
Here’s everything you need to know about pension plans, from their structure and types to taxation and payout options.
What are pension plans?
Pension plans are a type of retirement plan where an employer commits to pay a set monthly amount to employees when they retire. The amount is usually based on the employee’s salary and years of service, among other factors. The employer is primarily responsible for contributing to the plan and managing the investments. Pension plans are designed to provide a steady income stream for workers during retirement.
Only 15 percent of private industry workers had access to a traditional pension plan, also called a defined benefit plan, in March 2022, according to the Bureau of Labor Statistics.
How a pension plan works
Pension plans operate on the principle of accruing benefits over an employee’s career. During their employment, the employer contributes to the plan on behalf of the employee. The money is then invested, and the returns are added to the plan’s funds. Voluntary employee contributions may be allowed as well.
During retirement, the employee begins to receive monthly payments, the amount of which is determined by a formula that takes into account factors like the employee’s final salary and years of service. Pension benefits are typically payable for the remainder of the employee’s life.
Two types of pension plans
Pension plans can be categorized into two main types: defined benefit plans and defined contribution plans. Here’s a closer look at both.
Defined benefit plan
A defined benefit plan provides a specific monthly benefit at retirement, which is calculated using a formula that typically factors in salary, years of service and age. The employer bears the investment risk and is responsible for ensuring sufficient funds exist to pay the promised benefits.
These plans are often referred to as traditional pension plans, and they’re generally seen as more advantageous for workers since they provide a predictable income in retirement. However, they’re less common today due to their high costs and complexity for employers.
Defined contribution plan
In a defined contribution plan, the employer, employee or both make regular contributions to the employee’s individual account within the plan. The final benefit amount depends on the total contributions and the performance of underlying investments. The most common type of defined contribution plan is the 401(k).
While these plans give workers more control over their investments, they also transfer the investment risk from the employer to the employee.
Options for pension plan distribution
When it comes to receiving pension benefits, retirees typically have two main options: monthly annuity payments or a lump-sum distribution. The most suitable option depends on the retiree’s financial situation, life expectancy and personal preferences.
You can use a pension calculator to estimate your earnings and compare pension distribution options. You might also consider speaking with a financial advisor to determine which payout option works best for your retirement needs.
Annuity
An annuity distribution provides a steady stream of income for life. Some plans may offer options for survivor benefits, which continue payments to a spouse or other beneficiary after the retiree’s death. While annuities offer the security of a regular income, they may not keep pace with inflation.
Lump-sum
A lump-sum distribution pays out the entire value of a pension plan in one go. This can be an attractive option for those who want immediate access to their funds, have a shorter life expectancy or feel confident in managing their own investments. However, taking a lump sum can lead to higher taxes in the year of the distribution and poses the risk of running out of money if not properly managed.
Are pension plans taxable?
Pension plans are usually taxable. When retirees start receiving pension benefits, the payments are treated as ordinary income and are subject to federal income tax. Depending on where the retiree lives, the payments may also be subject to state income tax.
Advantages of pension plans
Pension plans offer several benefits, including:
- Guaranteed income: They provide a steady and predictable income in retirement, reducing the risk of outliving one’s savings.
- Employer-funded: Most of the funding for a pension plan comes from the employer, which can be a significant benefit for employees.
- Low maintenance: Since the employer is responsible for managing the plan’s investments, employees don’t have to worry about choosing and managing their own investments.
- Inflation protection: Some pension plans offer cost-of-living adjustments to help keep pace with inflation.
Risks associated with pension plans
While pension plans have their benefits, they also come with risks, particularly the financial health of the employer. If the company faces financial distress or goes bankrupt, it may not have the funds needed to meet its pension obligations.
Additionally, pension benefits are often based on the employee’s final years of salary and years of service. If an employee leaves the company before reaching retirement age, the pension benefit may be significantly reduced.
Finally, since pension plans are typically managed by the employer, workers have little to no control over the investments, so workers must trust that their employer or plan administrator is investing funds responsibly.
How pension plans compare to other retirement savings options
Traditional pension plans are becoming increasingly rare. Instead, defined contribution plans like 401(k)s are now the standard way most people save for retirement.
- 401(k) plan: This defined contribution plan allows employees to contribute a portion of their pre-tax salary to a retirement account. Employers often match a portion of the employee’s contributions.
- Traditional Individual Retirement Account (IRA): An IRA is a tax-advantaged account that individuals can open on their own, regardless of their employment status. Contributions are made with pre-tax dollars and provide a tax deduction in the year they’re made. However, taxes come due when withdrawals are made during retirement.
- Roth IRA: Contributions are made with after-tax dollars, so they aren’t tax deductible. However, withdrawals in retirement are tax-free.
401(k) vs. pension plan
Both 401(k) plans and pension plans offer workers income in retirement. But unlike pensions, which put the onus of saving for retirement on the employer, 401(k) plans require direct buy-in from workers.
Here are other similarities and differences between a 401(k) and a pension:
- Investment control: 401(k) participants pick the investments inside their accounts, while in a pension plan, the employer controls the investment decisions.
- Benefit predictability: Pensions offer a guaranteed benefit at retirement, while the benefit from a 401(k) depends on contribution amounts by employees and investment performance.
- Risk: With a pension, the employer bears the investment risk, while with a 401(k), the employee assumes the risk.
Frequently asked questions (FAQs)
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Pension plan vesting is the process by which you earn the right to the full benefits of a retirement plan. Your ownership percentage typically increases each year until you’re fully vested based on the plan’s terms. While your own contributions are always fully vested, employer contributions may have different rules, with some plans offering immediate vesting and others requiring several years of service before full vesting.
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A pension plan can indeed go bankrupt due to reasons like mismanagement of the underlying investments or the company itself going bust. Single-employer plans are typically more stable than multi-employer pensions. If your plan is insured by the Pension Benefit Guaranty Corporation (PBGC), they may cover benefits up to a certain limit in the event of bankruptcy.
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Your pension typically becomes available at retirement, usually at age 65. Some plans may offer early retirement options starting at age 55, but this could result in lower monthly benefits. The exact timing and amounts depend on the plan type and its rules. Check your plan documents or consult your plan administrator for details specific to your pension.
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Pensions are more common for certain types of workers, including public school teachers, state and local government employees, firefighters and police officers. Members of the military also often qualify for a pension after 20 years of service. Unionized workers in the private sector also have greater access to pensions than other types of private sector workers.
Bottom line
Pension plans can provide a reliable income stream in retirement, but they’re increasingly rare for the average worker. If you’re fortunate enough to have a pension plan, it’s essential to understand how your plan works, the benefits it provides and any potential risks. Ultimately, a diversified approach to retirement planning that combines different types of accounts and investments will help ensure a more secure and comfortable retirement.
