What is a pension and how does it work?

What is a pension & how does it work?

12.18.2023

It’s important to start planning and saving for retirement early in your career. The earlier you get started, the more time you have to plan for a comfortable retirement. Many people start saving for retirement in a workplace retirement plan like a 401(k). However, a handful of workers — mostly government workers — still have traditional pension plans available to them.

A pension plan is an employer sponsored retirement plan that gives employees a leg up on retirement planning. Unlike other more common retirement plans, they’re sometimes funded primarily by employers and guarantee employees a certain level of income during retirement.

What is a pension?

A pension plan, according to the U.S. Department of Labor, is a benefit plan established by either an employer or a union (or another employee organization) to help employees save for retirement. The plan, depending on the type offered, may either guarantee workers a certain income during retirement or help workers defer income for retirement.

Pension plans allow for certain tax benefits — we’ll discuss those benefits later — as long as certain rules are followed relating to participating, vesting, plan features, funding, and more.

The purpose of a pension plan, at its very core, is to help employees save for retirement. In some cases, that may be with primarily employer contributions, while in other cases, that may be primarily with employee contributions. But those contributions, paired with investment growth, can help provide a comfortable retirement for plan participants.

What is a pension fund?

Though the terms pension plans and pension funds are sometimes used interchangeably, they are actually quite different. As we’ve mentioned, a pension plan is an employer-sponsored retirement plan that’s funded by either employer or employee contributions (or a combination of the two).

A pension fund, on the other hand, is an investment fund that’s set up to benefit the participants in the pension plan.1 These funds, typically used for defined benefit plans, pool together the money of all plan participants. Pension funds are huge institutional investors in the U.S. stock market.

Types of pensions

The definition of a pension plan is more expansive than you may think. It includes what most of us traditionally think of as pension plans, as well as other workplace retirement plans. Each type of pension has its pros and cons, as we’ll discuss here.

Defined benefit pension plan

A defined benefit plan is what most of us think of when we picture a traditional pension plan. This type of plan is one an employer offers its employees and promises them a certain monthly income during retirement. The monthly benefit each employee is promised is based on their years of service with the company and their salary during those years.

Defined benefit plans have some major advantages for employees. As long as they remain with their employer for a certain number of years, they may have some or all of their retirement largely taken care of.

However, these plans are costly for employers and present some risks. For example, even if the plan’s investments perform poorly, the employer must still meet its obligations to its retired employees.

It used to be quite common for workers to be offered defined benefit plans. In fact, before the 1990s, more employees were enrolled in defined benefit plans than in other types of employer-sponsored retirement plans. However, the number has been dwindling.2

In 2022, 69% of private industry workers had access to workplace retirement plans. However, only 15% of workers had access to defined benefit plans. Most workers were only offered defined contribution plans. Government workers, which we’ll discuss in a later section, make up the vast majority of employees covered by defined benefit plans.3

Defined contribution pension plan

A defined contribution plan is one where employees have the ability to make contributions from their pay to the plan and the employer has the option to make additional contributions to its employees' plan account. Employees are not guaranteed a certain monthly benefit. The most common type of defined contribution plan is the 401(k) plan, but other examples include the 403(b) and 457(b) plans.

A defined contribution plan typically puts the investment risk on the employee. If the investments selected by the employee perform poorly, it’s only the employee that bears the losses. Additionally, it puts most of the onus on saving for retirement on the employee. Though employers often make contributions to the employees’ plan accounts, they are often done as matching contributions — meaning matching an employee’s contributions — and they aren’t likely to be sufficient to fund the worker’s entire retirement.

Despite the fact that defined contribution plans shift much of the risk from the employer to the employee, they still have some benefits for employees.

When you have a defined contribution plan, especially a 401(k), you have more control over the plan. You can contribute as much as you want, up to plan limits. You typically have the power to choose your own investments, and if you leave your job, you can bring your account balance with you, which may also include the portion contributed by your employer if you are vested in the plan.

Defined contribution plans also have some clear benefits for employers. Though 401(k) plans and other defined contribution plans still have administrative costs, these plans are considerably less costly than defined benefit plans.

A hybrid approach: Government pensions

The federal government, as well as many state and local governments, offer pensions that are like hybrids of the defined benefit and defined contribution plans.

Federal government employees are covered by the Federal Employee Retirement System (FERS), which is made up of three components: Social Security benefits, a Basic Benefit plan, and a Thrift Savings Plan (TSP).

Under the Basic Benefit plan, employees are offered a defined benefit, but only if they also contribute a portion of their income to the plan. As long as they do, the federal government will also make its contribution, and the employee will receive an annuity payment, starting when they retire and lasting for their entire lives.

The TSP portion of the FERS more closely resembles a 401(k) plan. The federal government contributes a small amount to each employee’s plan account. Employees are then free to contribute more to their own plans in the form of tax-advantaged contributions.

Many state and local governments offer programs similar to the federal government’s. Nearly 21 million workers participate in more than 5,500 government pension plans around the country.4 Each of these plans has its own makeup, meaning some are defined benefit plans, some are defined contribution plans, and others are hybrids of the two.

Advantages of pensions

Pensions have plenty of clear benefits, some of which are specific to either defined benefit or defined contribution plans, while others exist for both types of plans.

Tax relief

Pension plans offer several forms of tax relief for participants. First, pension contributions — with the exception of Roth contributions — are tax-deductible. They reduce your taxable income in the current year and ultimately help to lower your tax liability. This benefit is particularly advantageous for high-income earners who are in higher tax brackets. Not only could pension contributions help them reduce their taxable income, but they could also help push them into a lower tax bracket.

Another tax benefit pensions offer is a tax shelter. When you earn capital gains, dividends, and interest in a taxable account, you pay taxes on those earnings. But any earnings in your pension plan are tax-deferred until withdrawal.

Employer contributions

No matter what type of pension you have, you may receive employer contributions in your account. Defined benefit plans are funded largely by employer contributions. But even defined contribution plans can receive some employer contributions. In the case of matching contributions, those funds can create an immediate 100% return on your investment.

Consider this: A 6% contribution rate on a $100,000 salary to your 401(k) plan could result in nearly $1 million after 30 years, assuming a 10% annual return. If you also get a 6% employer contribution, you’ll have nearly $2 million.

Investment growth

Your and your employer’s contributions to your pension plan will be affected by investment growth and compound earnings throughout your working years. Your pension investment options will depend on the plan. A defined benefit plan will generally invest your contributions on your behalf with no input from you. And in the case of a defined contribution plan, you will likely have the ability to choose your own investments.

When choosing investments for your defined contribution plan, you can choose your plan’s default fund, which will may be a target-date fund. However, you can also choose other funds or even individual securities if a brokerage account is an available plan option.

Calculating your pension requirements

Many people simply choose a default amount to contribute to their retirement accounts each month and don’t change it for their entire career. But you’d be better served running the numbers to determine exactly how much you need to contribute to your retirement account to reach your retirement goals.

If you have a defined benefit plan, an online pension calculator can help you get an idea of your estimated monthly benefit at retirement based on your plan type, multiplier, current age, salary, and other factors.

If you have a defined contribution plan, it’s important to calculate how much you’ll need to contribute each month to reach your retirement goals. Factors to consider when determining your retirement needs should include your current financial situation, your retirement goals, your risk tolerance, your age, and more.

Read more: When can I retire?

Monitoring your account

Just as it’s important to calculate your necessary retirement contributions, it’s also critical that you monitor your account growth, at least if you have a defined contribution plan.

Your defined contribution plan is likely to fluctuate over time as the market moves. In some years, your account balance may go down, even with continued contributions. But in other years, your account may see significant growth.

Monitoring your retirement account on a regular basis can help you see how you’re progressing toward your retirement goals. And while you may want to avoid making impulsive changes to your investments based on market changes, it can be helpful to know if your current retirement investments are moving you in the right direction toward your goals.

Read more: Guide for deciding when to retire

When can you access your account?

Both defined benefit and defined contribution plans have age restrictions in place. These plans are designed to be used for retirement. To ensure they are used for that purpose, the federal government imposes a 10% penalty tax on any withdrawals before the allowed retirement age (excluding withdrawals for certain exemptions allowed under the regulations).

The age at which you can access your account depends on your employer and the type of  plan you have. First, private employees can typically access their defined contribution plans penalty-free starting at age 55, as long as they leave their jobs.

If you don’t qualify for the separation from service withdrawal, you can typically access your defined contribution plans penalty-free starting at age 59 ½. Finally, defined benefit plans often set their distribution age at either 62 or 65.

Tax implications of withdrawals

In most cases, withdrawals are subject to income taxes. The exception is for contributions to Roth accounts. Because Roth contributions are made after taxes, their distributions aren’t subject to income taxes if the account requirements are met.

If you’re concerned with how the tax advantages of your withdrawals may affect you, consider working with a financial advisor. A financial advisor can help you strategize your retirement contributions and withdrawals to minimize your tax burden, both today and during retirement.

Options for accessing your account

When you’re ready to access your account, there are a few options for how to do it. Here are a few to consider:

  • Buying an annuity: Some plans allow you to use your proceeds to buy an annuity, which will provide an annual income, either for a set number of years or for the rest of your life. Annuities have some risks, including the potential for below-market returns or passing away before you’ve had the chance to take full advantage of your benefits.
  • Drawdown plan: A drawdown plan allows you to take ongoing withdrawals from your account over a specific period of time, for a specific dollar amount or based on your life expectancy. The rest of the funds remain invested. The benefit of this plan is you can continue to participate in any stock market growth. However, you also open yourself up to market risk.
  • Lump sum withdrawal: Another option for withdrawing your account is to take a lump-sum withdrawal. This would have major tax consequences if you moved the money into a taxable account, but you could avoid the tax liability by rolling the funds into an individual retirement account (IRA).
  • Combining multiple strategies: You don’t have to choose just one of the strategies we’ve listed. You can combine two or more strategies by using some of your funds to buy an annuity, taking a lump sum or a portion of your account, and/or using a managed drawdown plan to collect the rest.

    Consider all your options and their features and fees before moving money between accounts.

Overcoming common barriers to pension planning

If you’re using a pension plan to help you save for retirement, there are some common barriers you must work to overcome to get the most out of your plan.

One of the most common barriers to overcome with pension planning — or any retirement planning, for that matter — is waiting too long to get started. Many people, especially those in their 20s or 30s, may put off retirement planning because of the belief that it’s too far away to prioritize. But the truth is that your best chance at a comfortable retirement is to start saving from the start of your career so your dollars have time to potentially grow and compound in the market.

Another barrier people have is balancing retirement savings with other financial goals. We’ve already talked about how retirement calculators can help you determine how much you must save for retirement to reach your goals. This type of planner can give you an idea of how much will be left in your budget to fund your other goals.

The final barrier of pension planning we’ll talk about — though not necessarily the final barrier overall — is the complexity of some pension plans. When you begin your retirement savings, it’s important to enlist help to get on the right track. That help could come in the form of an HR representative at your company, a financial advisor, or something else.

At the end of the day, it’s simply important to make sure you fully understand your employer’s plan and how best to utilize it to provide a comfortable retirement for yourself.

The bottom line

No matter what type of pension plan you have, it’s important to start taking advantage of it as early as possible. By making consistent contributions and investing your retirement assets well, you can use the power of a pension plan to help you reach a comfortable retirement. And if you have a defined benefit plan through your employer, your employer’s contributions can do the same.

 

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  1. CFA Institute Research & Policy Center. “Pension Funds.”
  2. U.S. Department of Labor, “Private Pension Plan Bulletin Historical Tables and Graphs 1975-2020,” October 2022.
  3. U.S. Department of Labor Statistics. “Retirement plans for workers in private industry and state and local government in 2022,” February 2023.
  4. Urban Institute. “State and Local Government Pensions.”

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Glossary Label
Pension plan
Glossary Definition
A pension plan is a benefit plan established by either an employer or a union (or another employee organization) to help employees save for retirement. The plan, depending on the type offered, may either guarantee workers a certain income during retirement or help them defer income for retirement.

The Currency editors

Staff contributors

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