What Is a Pension and How Does It Work?

A pension plan is an American worker's great insurance policy that can, if executed correctly, provide for a financially comfortable retirement. 

Pension plans date back to 1875, when The American Express Company established the first private pension plan in the U.S. In recent years, public pension plans have become less pervasive. For example, in 1980, more than 148,000 DB plans covered 30 million active workers. By 2008, approximately 48,000 DB plans covered 18.9 million U.S. workers. Additionally, a recent Towers Watson report stated that from 1998 to 2013, the number of Fortune 500 companies offering traditional pension plans declined by 86%, from 251 to 34.

What is a Pension Plan?

A pension plan is a type of retirement plan where an employee adds money into a fund that includes contributions by the employer. The worker's pension payments are determined by the length of the employee's working years and the annual income they earned on the job leading up to retirement.

How a Pension Plan Works

A pension plan is modeled after a traditional long-term retirement savings plan, where a company sets aside a fixed percentage of the employee's salary in a retirement savings account, and invests the account proceeds on the worker's behalf.

Over the years, those assets (usually invested in stocks, bonds and funds) appreciate and grow, providing the employee (hopefully) an ample income source during retirement.

Typically, upon retirement, the employee can choose to receive those pension benefits as a lump sum, or in a series of steady, annuity-like payments through the course of his or her retirement.

Pension plans are calculated based on three key criteria:

  • The employee's years of service at a specific company or organization.
  • The employee's age.
  • The employee's annual compensation.

Taxes on Pensions

Most pension plans are taxable, and you'll need to fully understand the amount of any potential tax on your pension plan proceeds.

For instance, you can work with your employer to figure out if it's best to have taxes taken out of your pension plan payments in retirement. Also, if after-tax cash was contributed to a pension, a portion of those proceeds could be considered tax-free (your employer or a professional tax accountant can provide clarity on that issue.)

In addition, an employee with a disability may also see taxes waived on his or her pension plan proceeds in retirement.

Pensions vs. 401(k)s

Unlike defined contribution plans, like 401(k) plans and 403b plans, pension plan participants aren't the stewards of their plans, and they don't make any investment decisions.

That responsibility goes to the employer, who manages the pension plan for the employee, makes all the portfolio investment decisions (i.e., what stocks, funds or bonds to pick), and disburses pension plan assets to the employee upon retirement.

In addition, with a defined contribution plan, the plan participant (i.e., the employee) decides how much to invest (or how much to "contribute") in a plan; selects the investment categories; and decides when those investment categories need to be changed.

Both defined contribution and defined benefit plans do have similar features, like tax-deferred growth and employer matching provisions.

Pension Vesting

Vesting decisions and timetables also play a big role in the pension plan process.

In a word, vesting is defined as the amount of pension plan proceeds the plan participant is entitled based on the duration of their time working for a specific company or organization.

Here are several facts pertaining to pension plan vesting:

  • Pension benefits can vest right away or can be spread out over a specific period, usually up to seven years.
  • Pension plan participants need to be aware of vesting timetables and schedules, as those issues directly impact whether an employee receives a full or a partial pension.
  • Pension plan participants also need to weigh vesting options if they plan to change jobs. In particular, an employee may not want to leave a job if he or she is fully vested, as that could negatively impact his or her retirement plan proceeds.

By and large, there are two forms of pension plan vesting - "cliff" and "graded":

Cliff Vesting

With cliff-vested pension plans, an employee would likely lose their pension plan proceeds if he or she left the employer before the vesting period - usually before five to seven years. If the employee leaves the job after the full vesting period, he or she is guaranteed a full pension based on the time he or she worked for the company.

Graded Vesting

In a graded pension-plan vesting scenario, an employee is entitled to, at minimum, 20% of his or her pension plan proceeds after three years on the job; with another 20% added in to the pension plan for every additional year on the job, up to the fully vested year amount, where the employee receives a 100% pension.

Alternatives to Company Pensions Plans

If your company doesn't offer a pension plan, you do have options.

For example, your company likely offers a 401(k) plan, or Individual Retirement Account plan option in lieu of a pension plan. Both are solid ways to accumulate retirement savings without a company pension.

You can also turn to a deferred or immediate annuity, where you make a one-time lump sum payment in return for guaranteed payments in retirement.

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