You can have a pension and still contribute to a 401(k)—and an IRA—to take charge of your retirement. If you have a defined benefit pension plan at work, you have nothing to worry about, right? Maybe not. While pensions used to be a staple ingredient in the recipe of retirement planning, fewer companies today offer them. What's more, the benefits aren't as reliable as they used to be.
- A pension provides a fixed monthly benefit upon retirement for the rest of your life.
- 401(k)s and IRAs provide income in retirement, too. But the amount depends on how much you contribute and how well your investments perform.
- A good retirement strategy is to contribute to a variety of retirement investments, including 401(k)s and IRAs—even if you already have a pension.
Now is a good time to start thinking about where your pension fits into your overall plan for retirement. It’s dangerous to rely on any pension—even a generous one—to cover all your retirement needs.
Traditional Pension Plans: A Blast from the Past
Pensions are terrific if you’re lucky enough to still have one. Until the 1970s, most workers had defined benefit pensions. They were originally designed to encourage employees to stay with one company for the long haul. The employee was rewarded for loyalty, and the company benefited from having a stable, experienced workforce.
As the name implies, these plans provide a fixed ("defined") payment during retirement—for as long as you live. Of course, if you'd rather have a single payment, you can elect a lump-sum distribution. You can even choose a combination of these two options.
Either way, your benefits are based on metrics, such as your age, earnings history, and years of service. Your employer funds the pension and takes on the investment risk. They also bear the longevity risk. That's the risk that plan participants will live longer—and collect more money—than the company expected.
The percentage of Fortune 500 companies that offered a defined benefit plan to new hires in 2017. Twenty years earlier, 59% of those companies did.
These days, defined benefit plans are still fairly common in the public sector (i.e., government jobs). But they've largely disappeared from the private workforce, where defined contribution plans now rule.
Defined Benefit vs. Defined Contribution Plans
During the 1970s, the government created several defined contribution plans, including 401(k)s and IRAs. These get their name because they are funded by employee contributions. The amount you receive at retirement depends on how much you contribute to the plan—and how well your investments perform.
While defined contribution plans were welcome creations for the self-employed, few realized at the time that they would eventually replace the cherished traditional pensions that employees had grown accustomed to.
Defined contribution plans are cheaper for employers to maintain and fund. They also shift the burden of retirement planning—and the longevity risk— to the employee.
For these reasons, traditional pensions are no longer part of the retirement equation for most workers.
Government Employees Still Get Pensions
Still, defined benefit plans are available to most government employees, whether they work at the federal, state, or municipal level. While it may be comforting to assume your retirement needs will be fully met by a government pension, that's not a good idea.
The amount that public pensions are underfunded by, according to recent estimates from Moody's Investors Service.
Many state and municipal employee pension plans are facing substantial shortfalls to cover future obligations. That means your pension might not be as ironclad as you once thought. Even government employees should be making additional plans to save for retirement.
Will My Pension Be Enough?
If you have a traditional pension plan, contact your HR department to find out what benefits you can expect at retirement. This is usually based on a percentage of your income that increases with the number of years you work for your employer.
It also depends on whether you have worked long enough at your company to be “vested” in your pension. Leave before that magic date and your pension rights disappear.
To figure out if your pension will be enough to retire comfortably, add your expected pension payment to your expected monthly Social Security benefit. If it's not enough—or if it's just barely enough—you’ll have to look at defined-contribution alternatives, such as a 401(k), traditional IRA, and Roth IRA, to make up the shortfall.
Of course, even if it looks like you're set for retirement, you should fund at least one other type of account—such as a 401(k). You never know what will happen to your pension. It's a good idea to have at least part of your retirement income under your control.
Watch Out for Inflation
Inflation is the “X-Factor” in retirement planning. Most private employer pension plans establish a fixed monthly benefit at the beginning of retirement and pay out that amount for the rest of your life.
While that might be very generous in the early years of retirement, you’ll begin to feel the pinch in ten years or so when your monthly benefit doesn’t buy as much as it used to.
To address this, government pensions typically have some type of cost-of-living adjustment (COLA). Still, that COLA might not address your specific needs.
COLAs are generally based on the Consumer Price Index (CPI), a general-purpose index. However, that can work against seniors. For example, healthcare is a major component of a retiree's household budget. Price levels in that sector are rising much faster than in the general economy. If the CPI is 2%, but your personal rate of inflation is 5%, you’ll fall behind, even with a COLA provision.
You should have some type of backup—such as a 401(k)—even if you’re expecting a government-sponsored, COLA-adjusted pension plan.
You Don’t Control Your Employer’s Pension Plan
A pension that looks good now can change—especially if it’s not part of a union contract or other mandate.
Your employer has absolute control over a defined-benefit plan (subject, of course, to federal law and any contracts). That means your company can generally change benefit calculations, reduce benefits, or even terminate the plan.
If so, your employer may arrange a payout to workers for their portions of the plan to date. However, in some cases, the funds are left in a poorly managed account that pays meager benefits until the last pensioned employee dies. Either way, you won’t get your expected monthly benefits.
Also, there’s a chance your company’s pension plan could fail. There are some protections in place to help preserve a portion of your pension plan—but not all of it.
Whenever possible, make sure your pension represents only a portion of your expected retirement income—not all of it.
The Bottom Line
The future of defined benefit pensions is tenuous at best. In addition to your pension, it’s a good idea to fund a defined contribution retirement plan—such as a 401(k) or 403(b)—if your employer offers one. Traditional and Roth IRAs are other good choices. And you can max out your contributions to both a defined contribution plan and an IRA during the same year.
Other ways to prepare for retirement include building up nonretirement investments (stocks, mutual funds, investment real estate), working to get out of debt, and even investigating post-retirement career opportunities.
A traditional pension is great if you have one, but never assume that your employer has your retirement fully covered. Ultimately, the quality of your retirement is your responsibility.