There are many different types of income that retired folks draw on, depending on what life during their working days was like. Two of the most widely-known income streams today include pensions and Social Security, two programs funded and structured in totally different ways.
While pensions are typically workplace retirement plans, in which an employer makes contributions to a pool of funds on behalf of employees, Social Security is handled by the federal government and funded through payroll taxes collected from employees and companies.
Read on for more about how the two programs are structured and how each may benefit retirees who have paid into such programs.
Before the advent of IRAs and 401(k) plans there were pensions. Your parents and grandparents, if they worked for the same company for many years, may have enjoyed generous pension benefits. Pensions nowadays are known officially as defined-benefit plans because the payment amount you'll receive in retirement is decided or defined in advance. (See also: How Does a Pension Plan Work After Retirement?)
A private pension is a retirement account created by an employer for the employees’ future benefit. Employers, governed by certain laws and regulations, contribute on the employee’s behalf and invest the money as they see fit. Upon retirement, the employee receives monthly payments. State government employees frequently have pension systems as well. For example, in Ohio, state workers pay into the Ohio Public Employees Retirement System in lieu of Social Security.
The private pension payout depends upon several factors, such as how long you worked for the employer as well what your salary was. In some cases, you can choose a lump-sum payment or a monthly annuity check. In the past, employers were required to maintain excess pension assets within the plan and were not to use the funds for other expenses. This law was put in place so that when needed by retirees, the money would be available to be paid out to eligible retired individuals. It also ensured that excess pension monies were available to offset the times when investment returns were lower than expected.
Many years ago, employers encouraged Congress to amend the pension rules and allow them to use money in over-funded pension plans for other employee benefits, such as retiree health plans and early-retirement payments. In her book How Companies Plunder and Profit from the Nest Eggs of American Workers, Ellen Schultz relates how these changes led many companies to move pension assets into unrelated company coffers. That resulted in a mass downsizing of pension monies and, ultimately, underfunded pension funds.
Private-sector pensions are gradually becoming obsolete, but 42 million Americans remain covered by them today.
Social Security Isn’t a Pension
Although many seniors receive Social Security benefits in retirement, the Social Security system isn't considered a pension. It may look like a pension because upon retirement, if you, your spouse, or a parent has paid into the system during your/their working years, you and they are eligible to receive monthly benefits. The amount of the check varies based on the age at which you begin receiving benefits as well as how many years you worked and the amounts you earned while you were contributing to the program. Social Security isn't designed to fully replace your income or meet all of your financial needs in retirement.
Social Security is funded by a pay-as-you-go system. This means that while you are working, you pay into the system. On your pay stub, the entry for Social Security taxes is listed as FICA. Some of the payments that you make while working go to fund retirees’ benefits as well as those remunerations of other Social Security recipients. (See also: How to Make Social Security Work.)
There are several other distinctions between pensions and Social Security. Social Security offers a disability insurance program that covers workers with enough credits (earned through work and payment into the system) if they become disabled. Pensions normally don’t provide disability benefits unless the employee is disabled in an on-the-job accident.
Although spouses may receive a partial pension payment ( see What are Social Security spousal benefits?), it’s unlikely that a child would also benefit from pension income — as is the case with Social Security. Finally, pensions may offer a lump-sum payout upon retirement. This option is not available through the Social Security system.
The Bottom Line
Both pensions and Social Security may provide an income stream to retirees. But not only are the two completely different in the way that they're funded and structured, the future of both faces different challenges. While the federal Social Security system will likely continue to provide aid to the disabled and elderly for many years – though by how much remains to be seen – pension-plan systems are dying out, being replaced by defined contribution plans such as IRAs and 401(k) plans.