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What is a Pension Plan?

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A pension plan is a type of employee benefit that some companies, organizations, and government entities offer to help their employees prepare for retirement. Pension plans, unlike other types of retirement plans, are often designed to guarantee workers a certain income during retirement, making them one of the most attractive for workers.

Pension plans used to be far more popular in the United States, but have become increasingly less common in recent decades. While more than half of U.S. employees participate in a workplace retirement plan, according to the Pension Rights Center, less than a quarter participate in a pension plan. That being said, they are still more common among government workers — roughly 94% of state and local government employees have access to a pension plan.

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In this guide, you’ll learn how pension plans work, how they differ from other employer-sponsored retirement plans, and some key characteristics you need to know.

Types of Pension Plans

Pension plans can be broken down into two categories: defined-benefit plans and defined-contribution plans. While both are considered pension plans, they offer very different guarantees to employees.

Defined-Benefit Plan

A defined-benefit plan is one that guarantees an employee a certain monthly benefit during retirement. The promised benefit is usually determined by an employee’s salary during their time with the company and their years of service.

With this type of pension plan, the employer makes most of the contributions, while employees may have the option of contributing money themselves. Regardless of investment returns, the employer is responsible for providing employees with their promised benefits during retirement.

Defined-benefit plans are the least common type of employer-sponsored retirement plan because of the financial responsibility they place on a company. According to data from the Bureau of Labor Statistics, only 15% of workers have access to a defined-benefit plan.

Defined-Contribution Plan

A defined-contribution plan guarantees employees a certain contribution to their retirement account, often as a certain percentage of their salary. For example, an employer may agree to contribute 5% of each employee’s salary to their retirement account.

While the contributions to employees’ accounts are guaranteed, their benefit during retirement is not. The benefit the employee ultimately receives will depend on their salary, their years with the company, how much they personally contributed to the account, and the account’s investment performance.

The majority of U.S. workers have access to a defined-contribution plan. They’re available to about 64% of workers, according to the Bureau of Labor Statistics.

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How a Pension Plan Works

How a pension plan works depends largely on whether it’s a defined-benefit or defined-contribution plan. While pension plans can fall into either category, they were traditionally defined-benefit plans. That type of plan is still available to some workers today.

In a defined benefit plan, your employer contributes money on your behalf, and you are often given the option of contributing as well. The employer invests the money in the pension plan, just as you would invest the money in your 401(k) plan or individual retirement account (IRA). Then, once you reach the retirement age set by your company, you’ll receive a guaranteed income.

A defined-contribution has many similarities in how it operates. Your employer will contribute money on your behalf, and your total contributions will depend on your salary and years of service with the company. The difference is that the benefit you receive during retirement will be based not on a promise from the company, but on the investment performance.

Unlike with other types of retirement plans, the money in a pension plan generally isn’t yours to take with you when you leave. In other words, you typically can’t roll it over into a 401(k) or IRA when you leave your employer. Instead, it stays with your previous employer, and you will receive the benefit from them during retirement.

While employers with defined-benefit plans are required to abide by their promises and deliver employees’ benefits, the money in the plan is insured by the Pension Benefit Guaranty Corporation, which was created in 1974 to encourage employers to continue to offer these plans and to ensure retirees received their benefits on time.

Pension Plan vs. Pension Fund

When money is contributed to a pension plan on behalf of an employee, it accumulates into a pension fund. The money within the fund is managed by a professional fund manager, who then invests it. Pension funds are considered institutional investors, and make up the largest investment block in most countries.

While the terms pension plan and pension fund are often used interchangeably, pension plan usually refers to the benefit offered to individual employees, while pension fund refers to the aggregated funds that are invested.

Pension funds are generally considered either single-employer or multiple-employer funds. A single-employer plan provides benefits to the employees of a single company, while a multiple-employer plan provides benefits to employees of multiple companies.

In the case of multiple-employer plans, the money from each company is pooled together into a single fund, may be either kept separate for each employer to provide their employee benefits, or kept together for the fund itself to pay the plan benefits for all companies.

Pension Plan vs. 401(k)

A 401(k) is another type of employer-sponsored retirement that has become far more popular than pension plans. A 401(k) is a type of defined-contribution plan, where employers promise to guarantee a certain percentage of an employer’s salary. Those contributions are often dependent on the employee contributing first.

For example, suppose an employer agrees to match an employee’s 401(k) contributions up to 50% of the first 6% the employee contributed. If your annual income was $100,000, you could contribute $6,000, and your employer would contribute an additional $3,000. You can contribute more than that $6,000, but your employer won’t contribute any more.

Because a 401(k) is a defined-benefit plan, there are no guaranteed benefits during retirement. Instead, the amount you’ll receive during retirement depends on the amount you and your employer contributed to the account, along with the performance of the investments.

A critical difference between 401(k) plans and pension plans is how the investments are managed. As we mentioned previously, the money contributed to a pension plan is pooled together into a pension fund, which is invested together. But in the case of a 401(k) plan, each employee can choose their own investments, usually from a select list provided by the employer.

The Employee Retirement Security Act (ERISA)

The Employee Retirement Security Act of 1974 (ERISA) is a federal law that regulates most retirement and health plans in the United States.

ERISA sets many requirements for workplace retirement plans, including:

  • Requiring plan administrators to provide participants with important plan information, including its features and how it’s funded
  • Sets minimum standards for the participating, vesting, and benefit accrual of workplace retirement plans
  • Requires that those who manage and control retirement plan assets act as fiduciaries
  • Mandates that plan administrators create a grievance and appeals process for plan participants
  • Allows plan participants to sue when the manager has breached their fiduciary duty
  • Guarantees payment of certain benefits from the Pension Benefit Guaranty Corporation if a defined-benefit plan is terminated

The requirements laid out in ERISA don’t apply to all employees. For example, the law doesn’t cover government entities, churches, or plans maintained specifically to comply with unemployment, disability, or workers’ compensation laws.

Are Pension Plans Taxable?

The money contributed to your pension plan is tax-deferred, meaning you don’t pay taxes on it at the time it’s contributed. However, when you receive distributions during retirement, they’ll be considered taxable income, and you’ll owe federal income taxes on that money at your normal tax rate.

In some cases, pension plan participants may be allowed to receive their pension plan benefit as a lump-sum payout. In that case, you’ll owe income taxes on the entire amount in the year you receive the money.

Depending on where you live, you may or may not pay state income taxes on your pension distributions. Some states don’t tax pension payments and will allow you to receive them as tax-free income. Other states, however, require that you pay income taxes on the money.

Pension Plans and Vesting

When you start working for a new employer, you may be required to work there for a specific amount of time before you become eligible to participate in the workplace retirement plan. Earning the right to participate in these benefits is called vesting. With some employers, vesting happens immediately. With others, you may be required to work there a certain number of years before you’re fully vested.

Under ERISA, employers can choose between a cliff or graduated vesting schedule. Under a cliff vesting schedule, you don’t vest at all until you’re with the company a certain number of years. But once you reach that tipping point, you’re 100% vesting. A graduated vesting schedule is when employees become partially vested each year until they reach 100%. Employers can require a maximum of five years for cliff vesting and six years for graduated vesting.

No matter what your company’s vesting schedule, you are always 100% vested in your own contributions. Suppose your employer has a five-year cliff vesting schedule. During your first five years with the company, you automatically have a right to any money you contribute to the plan. Then, once you’ve been there five years, you also have a right to any money your employer has contributed thus far.

If you leave the company before you’re fully vested, you may receive only part of your employer’s promised benefit during retirement (or even none at all, in the case of a cliff vesting schedule).

Pension Plan Distribution Choices

When it’s time to start receiving your pension plan benefits during retirement, you may be given distribution options to choose from. Often, you can decide between either monthly annuity payments or a single lump-sum payment. Often the lump-sum payment will then be deposited into an IRA, where it will continue to be invested.

The primary benefit of the monthly pension payments is that you’re promised those monthly payments during your retirement. All of the investment risk is on the employer, so no matter what happens to the economy, your payments are guaranteed. Even in the event that your former employer goes out of business, pensions are insured by the Pension Benefit Guaranty Corporation. This type of payment structure is also ideal for those who don’t believe they can responsibly manage the full amount on their own.

On the other hand, the lump-sum payment to deposit into an IRA might be well-suited to those who feel they can best manage the money themselves. After all, someone can earn a higher return in their IRA than the employer’s promised benefit. However, investors in this situation take on all the investment risk. If the stock market takes a turn for the worse, your income during retirement could be less than you hoped.

Do You Need a Pension Plan?

Pension plans — especially defined-benefit plans — are becoming increasingly less common, as more employers have put the responsibility on workers to fund their own retirements. That being said, you may still have a pension available to you.

According to data from the Bureau of Labor Statistics, about 3% of workers have access only to a defined-benefit plan, while another 12% have both a defined-benefit and defined-contribution plan available to them. If this type of plan is available to you, it’s certainly worth participating. It’s usually funded primarily by the employer, meaning it doesn’t have to cost you anything, but still provides you with a guaranteed income during retirement.

If you don’t have a pension plan available to you, you probably still have options. A 401(k) plan is still an excellent option to help you save for retirement. This type of plan comes with serious tax advantages, allowing workers to reduce their taxable income by putting money into their retirement account. And while this type of plan puts the responsibility primarily on the employee rather than the employer, it’s still preferable to not contributing to a retirement account at all.

And while 401(k) plans may be less attractive than pension plans in some ways, they also have some advantages over them. First, you can choose your own investments for your 401(k) plan — at least within the confines of the options provided by your company. Additionally, you can take your 401(k) with you when you leave a company, unlike a pension plan that likely must stay with the company.

The Bottom Line

No matter what type of plan you have available to you, it’s important to prioritize retirement savings. If your company offers a pension plan, then you’d probably be well-served to take advantage of it. If no pension plan is available, then a 401(k) or even an IRA (or both) can still help you prepare for a financially comfortable retirement.

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Personal Capital compensates Erin Gobler (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

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