Pension Plan

What is a Pension Plan?

Louis DeNicola

The term pension plan might summon visions of your grandparents enjoying their retirement, but it also might be on the list of benefits when you start a job. They aren’t as common as they used to be, but it’s still worth knowing how pension plans fit into a retirement strategy.

A traditional pension plan is an employer-sponsored retirement plan that guarantees retired employees an income for the rest of their lives. In the private sector, employer pension plans aren’t as common as other types of employer-sponsored plans, such as 401(k)s.

If you’re offered a pension plan and 401(k) as part of your fringe benefits, you’ll want to understand how they work and whether a pension is a good option.

How Do Pension Plans Work?

What is a Pension?

Pension plans may work a little differently depending on your employer and the plan. But generally, employers set aside money in a pension fund for their employees. The money is invested, and the funds pay for retired employees’ pensions. You may need to work for an employer for a certain number of years — a vesting period — to become eligible for a pension. Once you’re eligible and reach retirement age, you can apply to receive pension payments, which could continue for the rest of your life.

How Much Will You Receive With a Pension Plan?

The pension amount can depend on a few things:

  • The plan
  • How many years you worked at the company
  • Your average salary at the end of your tenure (or at the point when you earned the most)
  • A multiplier.

For example, an employer may have a plan with a 2% multiplier. Someone who worked for the company for 20 years and had an average salary during the last three years of $90,000 might receive 20 x 90,000 x .02 = 36,000 per year. Or $3,000 each month for the rest of their life.

Similar to Social Security payments, your payment amount may increase the longer you wait to start collecting your pension. There may also be an option to receive a lump sum upfront rather than a monthly payment. Or to get a lower payment with a guarantee that your spouse will receive payments after you pass.

What Happens if Your Employer Can’t Afford Its Pension Payments?

Your payment amount might not depend on how much money is in the pension fund. To ensure it can meet its obligations, private employers may pay premiums to the Pension Benefit Guaranty Corporation (PBGC). The PBGC guarantees monthly pension plan payments (up to a limit) if a company files bankruptcy or can’t afford its payments.

Pension Plan vs. 401K

Traditional pension plans are also called defined-benefits plans because your benefit is predetermined. In contrast, a 401(k) is a defined-contribution plan which lets employees choose how much they want to contribute to their plan.

Many private employers have shifted away from offering pension plans to 401(k)s, or no retirement plans at all. According to March 2020 data from the U.S. Bureau of Labor Statistics (BLS), 15% of private industry employees had access to a defined-benefit plan, and 47% had access to a defined-contribution plan.

Two of the main differences between pensions and 401(k)s are who contributes to the plan and takes on the risk.

With pensions, the employer will primarily contribute to the plan. They also have to manage their investments and ensure they can fulfill their promise to make payments later.

A 401(k) shifts the risk to employees. You’ll primarily be the one funding the plan, although some employers match a portion of your contributions. You also have to make the investment decisions, and there’s no guarantee that you’ll have enough (or any) money for your retirement years.

There are other differences between pensions and 401(k)s as well:

difference between pension and 401k

Individual Retirement Account (IRA)

Unlike employer-sponsored plans, an individual retirement account (IRA) isn’t connected to an employer. As long as you meet the requirements, you can open and contribute to a traditional or Roth IRA on your own.

These tax-advantaged retirement accounts can be popular options for people who are self-employed and who don’t have access to an employer-sponsored option. You can also use an IRA to set aside money to supplement a pension or 401(k).

Also, if you have a 401(k) from a previous employer, you may be able to roll it over to an IRA. You can then have more control over where you invest your money — and the IRA may have fewer fees than the 401(k).

Private vs. Public Pension

In general, public pensions are much more prevalent than pensions from private employers. For example, teachers, firefighters and other public service workers may have public pensions. The BLS report found 86% of state and local government employees had access to a defined-benefit plan in March 2020 (18% had access to a defined-contribution plan).

Some potential differences between private and public pensions include:

  • Public pension employees may regularly contribute to their pension plan, while private pension plans are often completely funded by employers. You may be able to get these contributions refunded if you leave the job.
  • Public pensions may offer cost-of-living adjustments. Private pension payments may stay the same for the entire payment period.
  • Public pensions don’t have to pay for PBGC coverage, which could put your pension at risk if the municipality or state declares bankruptcy.
  • Public pensions may be portable, letting you move from one public job to another without completely losing your progress or benefits.
  • The specifics can vary depending on the public and private pension plans.

Do I Need a Pension Plan?

You don’t need a pension to have a good retirement. But if your employer offers a pension, sticking with the job until you’re vested is a good idea.

Defined-contribution plans like 401(k) may offer a few benefits. For instance, they’re portable (you keep the money when you leave the job) and you get to pick your investments. But employer-funded pension plans can offer several advantages:

  • You’ll have a set benefit for life, which can make it easier to plan your retirement.
  • You generally won’t need to make contributions to private pensions, which can leave you with more money in your bank account.
  • You can still contribute to an IRA and a 401(k).

Often, you won’t have the option of choosing between a 401(k) and a pension plan. If you’re considering a job change or job offer, the employer’s retirement plan offerings could be part of the consideration.

Pension Plan Wrap-up

Defined-benefit pension plans and defined-contribution 401(k) plans can both help you fund your retirement. However, you might not get to choose which type of plan you can use. And, in either case, pensions and 401(k)s may only be a piece of the puzzle. Social Security benefits, IRAs and other sources of income could all be part of your retirement plan.

No matter how close you are to retiring, you can learn more about finances and preparing for retirement on LifeLime.

This informational material shall not be considered financial advice. The Hartford assumes no responsibility for any financial, investment, or tax-related decisions. Those seeking resolution of specific financial, legal, tax, or business issues, questions, or concerns regarding this topic should consult their own financial, investment, tax, legal, or other business consultants, advisors, or other professionals.

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