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.