You probably already know a little bit about pension plans - either you have one or someone you know does - but the financial underpinnings behind a pension are familiar to few. Pension offerings have become scarce in the private sector, and it's important to understand why. In this article, we'll explore why employees love pension plans, and why companies try their hardest to avoid them.

What is a pension?
A pension is a company-sponsored fund that is supposed to provide a company's employees with a livable income for their retirement years. Generally speaking, there are two types of pensions - defined-contribution plans and defined-benefit plans.

  • Defined-contribution plans are the simpler of the two (and the more common today). In a defined contribution plan, the amount of money contributed to the plan by the company is set from the get go (often as a percentage of what the employee contributes). The money is then invested over the span of the employee's career, and the eventual balance in the account is paid out upon retirement. With this type of plan, the value of the employee's pension is based on the performance of the investments, so the eventual benefit to the employee is uncertain.
  • Defined-benefit plans, on the other hand, specify the ultimate payouts to retirees, regardless of the returns on the pension fund's investments. In a defined-benefit plan, the company is on the hook for whatever the fund can't generate. This is one of the principal reasons that defined-benefit plans are becoming a thing of the past - much to the chagrin of those entering the workforce. While some organizations are keeping their defined-benefit plans (such as major league sports organizations), many companies are freezing defined-benefit pension funds, restricting their participation to those employees who are already enrolled. (To learn more about the shift away from defined benefits plans, see The Demise Of The Defined-Benefit Plan.)

The Employee Perspective
Nowadays, you might wonder just how relevant pensions are for an employee - scores of Americans don't have pensions (either because they're self-employed or because their employers don't offer them). With an all-but-condemned Social Security system, many people are relying solely on self-directed retirement programs such as 401(k)s and IRAs. There is a growing number of people who retired with pensions, but then saw their plans collapse as their pensions' sponsor companies hit hard times. (To learn more about social security, see Introduction To Social Security.)

If you are able to join your company's pension program, the pension not only provides the asset growth of a self-directed retirement account, it also compounds its power with contributions from your employer. Recent legislation means that pensions are better protected today than in the past. The legislation was in response to major pension collapses that occurred in the '90s. However, having a pension isn't an excuse to avoid saving money for retirement - far from it. Even those lucky few with pensions should hold retirement accounts outside of their companies' plans. (To learn about pension risk, see: Analyzing Pension Risk and How To Evaluate Pension Risk By Analyzing Annual Costs.)

The Company Perspective
When companies sponsor a pension plan for their employees, they're essentially making an unofficial statement about how important their employees are to their bottom lines. Many CEOs justify limiting pensions by citing "responsibilities to shareholders", but providing adequate retirement planning is often in a company's best interests.

For example, companies get tax advantages from pension plans, although the tax advantages only kick in if a certain percentage of employees enroll in the plan. This helps ensure that the plan is a valid retirement choice, and not just an empty offering.

That said, pensions are also expensive for companies. Also, accounting standards for pensions aren't up to the standards many accountants feel they should be. For example, the Pension Benefit Obligation (PBO) - the present-valued dollar value a company estimates it will need to fund its pension plan - doesn't have to be reported on a company's books. Only a fraction of the PBO is reported in financial statements. This can lead to pension funds that are under-funded, which, unfortunately, leaves many pension funds in a position similar to that of Social Security.

The PBO is determined by actuaries through a series of calculations and permutations that only a math major could love. Because pensions are so complex, it's only natural that most people run for cover when faced with having to decipher a plan's financial mechanisms. Furthermore, plan assets (the actual assets that a pension plan has available) technically don't belong to the company and, therefore, they're also not reported on the balance sheet. Instead, most pension-related information is reported in footnotes to the financial statements. (To learn more, read Footnotes: Start Reading The Fine Print.)

A Pension and You
So, how important should a pension be the next time you're in the job market? While other retirement options can be a good fit - particularly if you've planned sufficiently - having your money professionally managed in a stable, structured pension can make a significant difference in the long term.

Whether you're planning on sunbathing on a Florida beach or heading to your New England cottage, your retirement should be something to look forward to. It shouldn't be a nagging doubt that you avoid thinking about. While retirement options are ever-evolving, having a clue about how your pension works can definitely help make your retirement more worry free.

Related Articles
  1. Investing

    Why Is Financial Literacy and Education so Important?

    Financial literacy is the confluence of financial, credit and debt knowledge that is necessary to make the financial decisions that are integral to our everyday lives.
  2. Retirement

    5 Ways to Use Your Home to Retire

    Retirement is going to cost a lot, and for homeowners who face a shortfall, their home can be a source of income. From downsizing to renting, here's how.
  3. Investing

    10 Ways to Effectively Save for the Future

    Savings is as crucial as ever, as we deal with life changes and our needs for the future. Here are some essential steps to get started, now.
  4. Mutual Funds & ETFs

    Mutual Funds Millennials Should Avoid

    Find out what kinds of mutual funds are unsuitable for millennial investors, especially when included in millennial retirement accounts.
  5. Retirement

    Retire on 70% of Your Income? Why It's Not Enough

    Many people think 70% will be enough to support them in retirement, but they forget a few significant expenses that could lurk in the future.
  6. Retirement

    This Is How You Could Live in Costa Rica for $1,000 a Month

    Explore the cost of living in Costa Rica, and learn how you could sustain a nice middle-class lifestyle for yourself on about $1,000 a month.
  7. Professionals

    How to Protect Your Portfolio from a Market Crash

    Although market crashes are usually bad news for your portfolio, there are several ways to minimize losses or even profit outright from market movement.
  8. Professionals

    Why Women Are Underprepared for a Spouse’s Death

    Women are typically less prepared for the death of a spouse than men. An advisor can help mitigate some of the financial burdens widows may end up facing.
  9. Retirement

    How Robo-Advisors Can Help You and Your Portfolio

    Robo-advisors can add a layer of affordable help and insight to most people's portfolio management efforts, especially as the market continues to mature.
  10. Professionals

    3 Benefits of Working Longer (and Retiring Later)

    There are many reasons why folks in their 60s may want to keep working until at least age 70. Here are three.
  1. What are some examples of items that count as comprehensive income?

    In business accounting, other comprehensive income, or OCI, includes those revenues, expenses, gains and losses that have ... Read Full Answer >>
  2. Can I borrow from my annuity to put a down payment on a house?

    You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
  3. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  4. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  5. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
  6. Are Cafeteria plans exempt from Social Security?

    Typically, qualified benefits offered through cafeteria plans are exempt from Social Security taxes. However, certain types ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!