What Is a Pension? How It Works, Taxation, and Types of Plans

Pension Plan

Investopedia / Ryan Oakley

What Is a Pension Plan?

A pension plan is an employee benefit that commits the employer to make regular contributions to a pool of money that is set aside in order to fund payments made to eligible employees after they retire.

Traditional pension plans have become increasingly rare in the U.S. private section. They have been largely replaced by retirement benefits that are less costly to employers, such as the 401(k) retirement savings plan.

Still, according to the 2021 U.S. Census, over 6,000 public sector retirement systems exist and manage $4.5 trillion of portfolio assets for 14.7 million working members. In addition, roughly 15% of private employees in the U.S., are covered by a defined-benefit plan today according to the Bureau of Labor Statistics.

Key Takeaways

  • A pension plan is a retirement plan that requires an employer to make contributions to a pool of funds set aside for a worker's future benefit.
  • There are two main types of pension plans: the defined benefit and the defined contribution plan.
  • A defined benefit plan guarantees a set monthly payment for life (or a lump sum payment on retiring).
  • A defined contribution plan creates an investment account that grows throughout the employee's working years. The balance is available to the employee upon retiring.
  • Pension funds are primarily funded by the employer, while 401k plans are primarily funded by the employee.
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Pension Plan

Understanding Pension Plans

A pension plan requires contributions by the employer and may allow additional contributions by the employee. The employee contributions are deducted from wages. The employer may also match a portion of the worker’s annual contributions up to a specific percentage or dollar amount. There are two main types of pension plans: the defined-benefit and the defined-contribution plans.

The Defined-Benefit Plan

In a defined-benefit plan, the employer guarantees that the employee will receive a specific monthly payment after retiring and for life, regardless of the performance of the underlying investment pool. The employer is thus liable for a specific flow of pension payments to the retiree, in a dollar amount that is typically determined by a formula based on earnings and years of service.

If the assets in the pension plan account are not sufficient to pay all of the benefits that are due, the company is liable for the remainder of the payment. Defined-benefit employer-sponsored pension plans date from the 1870s. The American Express Company established the first pension plan in 1875. At their height in the 1980s, they covered 38% of all private-sector workers.

The Defined-Contribution Plan

In a defined contribution plan, the employer commits to making a specific contribution for each worker who is covered by the plan. This may be matched by contributions made by the employees. The final benefit received by the employee depends on the plan's investment performance. The company’s liability ends when the total contributions are expended.

The 401(k) plan is, in fact, a type of defined-contribution pension plan, although the term "pension plan" is commonly used to refer to the traditional defined-benefit plan. The defined contribution plan is much less expensive for a company to sponsor, and the long-term costs are difficult to estimate accurately. They also put the company on the hook for making up any shortfalls in the fund.

For this reason, a growing number of private companies are moving to the defined contribution plan. The best-known defined contribution plans are the 401(k), and its equivalent for non-profit employees, the 403(b).

Variations

Some companies offer both types of plans. They even allow participants to roll over 401(k) balances into defined-benefit plans. There is another variation, the pay-as-you-go pension plan. Set up by the employer, these may be wholly funded by the employee, who can opt for salary deductions or lump sum contributions (which are generally not permitted on 401(k) plans). Otherwise, they are similar to 401(k) plans, except that they rarely offer a company match. 

A pay-as-you-go pension plan is different from a pay-as-you-go funding formula. In the latter, current workers’ contributions are used to fund current beneficiaries. Social Security is an example of a pay-as-you-go program.

Defined-Benefit Plan
  • Specifies exactly how much retirement income an employee receives once they retire

  • Employer contributions often not capped at 25% of pay

  • Annual contribution often does not have dollar limit

  • Administration cost is often higher

Defined-Contribution Plan
  • Specifies exactly how much each party must contribute to a plan to receive an unknown amount at retirement

  • Employer contributions often capped at 25% of pay

  • Annual contribution often has dollar limit per person

  • Administration cost is often lower

Pension Plans: Factoring in ERISA

The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that was designed to protect the retirement assets of investors. The law establishes guidelines that retirement plan fiduciaries must follow to protect the assets of private-sector employees.

Companies that provide retirement plans are referred to as plan sponsors (fiduciaries), and ERISA requires each company to provide a specific level of information to employees who are eligible. Plan sponsors provide details on investment options and the dollar amount of any worker contributions that are matched by the company.

Employees also need to understand vesting, which refers to the amount of time that it takes for them to begin to accumulate and earn the right to pension assets. Vesting is based on the number of years of service and other factors.

Pension Plans: Vesting

Enrollment in a defined-benefit plan is usually automatic within one year of employment, although vesting can be immediate or spread out over as many as seven years. Leaving a company before retirement may result in losing some or all pension benefits.

With defined contribution plans, an individual's contributions are 100% vested as soon as they are paid in. If your employer matches those contributions or gives you company stock as part of a benefits package, it may set up a schedule under which a certain percentage is handed over to you each year until you are "fully vested."

Just because retirement contributions are fully vested doesn’t mean you’re allowed to make withdrawals, however.

Vesting terms will vary from employer to employer. Contact your Human Resources department to understand what your current vesting terms are.

Are Pension Plans Taxable?

Most employer-sponsored pension plans are qualified, meaning they meet Internal Revenue Code 401(a) and Employee Retirement Income Security Act of 1974 (ERISA) requirements. That gives them their tax-advantaged status for both employers and employees.

Contributions employees make to the plan come "off the top" of their paychecks—that is, are taken out of the employee's gross income. That effectively reduces the employee's taxable income, and the amount they owe the IRS come tax day. Funds placed in a retirement account then grow at a tax-deferred rate, meaning no tax is due on the funds as long as they remain in the account.

Both types of plans allow the worker to defer tax on the retirement plan’s earnings until withdrawals begin. This tax treatment allows the employee to reinvest dividend income, interest income, and capital gains, all of which generate a much higher rate of return over the years before retirement.

Upon retirement, when the account holder starts withdrawing funds from a qualified pension plan, federal income taxes are due. Some states will tax the money, too.

If you contributed money in after-tax dollars, your pension or annuity withdrawals will be only partially taxable. Partially taxable qualified pensions are taxed under the Simplified Method.

Can Companies Change Plans?

Yes. Some companies are keeping their traditional defined-benefit plans but are freezing their benefits, meaning that after a certain point, workers will no longer accrue greater payments, no matter how long they work for the company or how large their salary grows.

When a pension plan provider decides to implement or modify the plan, the covered employees almost always receive credit for any qualifying work performed prior to the change. The extent to which past work is covered varies from plan to plan.

When applied in this way, the plan provider must cover this cost retroactively for each employee in a fair and equal way over the course of his or her remaining service years.

Pension Plan vs. Pension Funds

When a defined-benefit plan is made up of pooled contributions from employers, unions, or other organizations, it is commonly referred to as a pension fund.

Managed by professional fund managers on behalf of a company and its employees, pension funds can control vast amounts of capital and are among the largest institutional investors in many nations. Their actions can dominate the stock markets in which they are invested.

Pension funds are typically exempt from capital gains tax. Earnings on their investment portfolios are tax-deferred or tax-exempt.

A pension fund provides a fixed, preset benefit for employees upon retirement, helping workers plan their future spending. The employer makes the most contributions and cannot retroactively decrease pension fund benefits.

Voluntary employee contributions may be allowed as well. Since benefits do not depend on asset returns, benefits remain stable in a changing economic climate. Businesses can contribute more money to a pension fund and deduct more from their taxes than with a defined contribution plan.

A pension fund helps subsidize early retirement for promoting specific business strategies. However, a pension plan is more complex and costly to establish and maintain than other retirement plans. Employees have no control over the investment decisions. In addition, an excise tax applies if the minimum contribution requirement is not satisfied or if excess contributions are made to the plan.

An employee’s payout depends on the final salary and length of employment with the company. No loans or early withdrawals are available from a pension fund. In-service distributions are not allowed to a participant before age 59 1/2. Taking early retirement generally results in a smaller monthly payout.

Pension Plans vs. 401(k)

A pension plan and 401(k) can be both be used to invest money for retirement. However, each vehicle has its own strengths and weaknesses.

While a pension plan is often primarily funded by an employer, a 401(k) is often primarily funded by an employee. Employees can choose contribution amounts into a 401(k) with potential matched funds from employers based in IRS contribution limits. A 401(k) is a type of defined-contribution plan, while a pension may be a defined-contribution plan.

Under a 401(k) plan, investors often have greater control of their retirement plan including what investments their retirement savings are put towards as well as how much to contribute towards retirement. On the other hand, pension plans are more suitable for investors who wanted a guaranteed fixed income for life.

Another key difference between a pension plan and 401(k) is the portability. When an employee leaves a company, they can take their 401(k) with them by rolling over the balance into an individual retirement account (IRA). Alternatively, when an employee leaves a company in which they have a vested pension benefit, the employee must keep track of their pension benefit after they have left the company. Then, when the individual is ready to retire, they must apply for the pension benefits.

Pension Plans
  • Risk is placed on employer to guarantee and manage funds

  • Set income for life is guaranteed

  • Employers have greater control over investments and strategy

  • May have longer vesting period

  • Can not be immediately retained or rolled to different retirement account when leaving company

401(k) Plans
  • Risk is placed on employee to oversee and manage funds

  • No guarantee of any benefits/stable income

  • Employees have greater control over investments and strategy

  • May have shorter vesting period

  • Can be immediately retained and rolled into different retirement account when leaving company

Monthly Annuity or Lump Sum?

With a defined-benefit plan, you usually have two choices when it comes to distribution: periodic (usually monthly) payments for the rest of your life, or lump-sum distribution.

Some plans allow participants to do both; that is, they can take some of the money in a lump sum and use the rest to generate periodic payments. In any case, there will likely be a deadline for deciding, and the decision will be final. There are several things to consider when choosing between a monthly annuity and a lump sum. 

Annuity

Monthly annuity payments are typically offered as a choice of a single-life annuity for the retiree-only for life, or as a joint and survivor annuity for the retiree and spouse. The latter pays a lesser amount each month (typically 10% less), but the payouts continue until the surviving spouse passes away.

Some people decide to take the single life annuity. When the employee dies, the pension payout stops, but a large tax-free death benefit is paid out to the surviving spouse, which can be invested.

Can your pension fund ever run out of money? Theoretically, yes. But if your pension fund doesn’t have enough money to pay you what it owes you, the Pension Benefit Guaranty Corporation (PBGC) could pay a portion of your monthly annuity, up to a legally defined limit.

For 2022, the monthly maximum PBGC guarantee for a straight-life annuity for a 65-year-old retiree is $6,204.55. Meanwhile, the PGBC maximum monthly guarantee for joint and 50% survivor annuity is for a 65-year-old retiree is $5,584.10. Of course, PBGC payments may not be as much as you would have received from your original pension plan.

Annuities usually pay at a fixed rate. They may or may not include inflation protection. If not, the amount you get is set from retirement on. This can reduce the real value of your payments each year, depending on the rate of inflation at the time.

Lump-Sum

If you take a lump sum, you avoid the potential (if unlikely) danger of your pension plan going broke. Plus, you can invest the money, keeping it working for you—and possibly earning a better interest rate, too. If there is money left when you die, you can pass it along as part of your estate.

On the downside, there's no guaranteed lifetime income. It’s up to you to make the money last.

And unless you roll the lump sum into an IRA or other tax-sheltered accounts, the whole amount will be immediately taxed and could push you into a higher tax bracket.

If your defined-benefit plan is with a public-sector employer, your lump-sum distribution may only be equal to your contributions. With a private-sector employer, the lump sum is usually the present value of the annuity (or more precisely, the total of your expected lifetime annuity payments discounted to today's dollars).

Of course, you can always use a lump-sum distribution to purchase an immediate annuity on your own, which could provide a monthly income stream, including inflation protection. As an individual purchaser, however, your income stream will probably not be as large as it would with an annuity from your original defined-benefit pension fund.

Which Yields More Money: Lump-Sum or Annuity?

With just a few assumptions and a small math exercise, you can determine which choice yields the largest cash payout.

You know the present value of a lump-sum payment, of course. To figure out which makes better financial sense, you need to estimate the present value of annuity payments. To figure out the discount or future expected interest rate for the annuity payments, think about how you might invest the lump sum payment and then use that interest rate to discount back the annuity payments.

A reasonable approach to selecting the discount rate would be to assume that the lump sum recipient invests the payout in a diversified investment portfolio of 60% stocks and 40% bonds. Using historical averages of 9% for stocks and 5% for bonds, the discount rate would be 7.40%.

Imagine that Sarah was offered $80,000 today or $10,000 per year for the next 10 years. On the surface, the choice appears clear: $80,000 versus $100,000 ($10,000 x 10 years). Take the annuity.

However, the choice is impacted by the expected return (or discount rate) Sarah expects to receive on the $80,000 over the next 10 years. Using the discount rate of 7.40%, calculated above, the annuity payments are worth $68,955.33 when discounted back to the present, whereas the lump-sum payment today is $80,000. Since $80,000 is greater than $68,955.33, In this case, Sarah would take the lump-sum payment.

This simplified example does not factor in adjustments for inflation or taxes, and historical averages do not guarantee future returns.

There are financial calculators online to help make the decision on whether to take a lump sum vs. monthly distributions; otherwise, a financial advisor can help guide the decision.

Other Deciding Factors

There are other basic factors that must almost always be taken into consideration in any pension maximization analysis. These variables include:

  • Your age
  • Your current health and projected longevity
  • Your current financial situation
  • The projected return for a lump-sum investment
  • Your risk tolerance
  • Inflation protection
  • Estate planning considerations

How Does a Pension Work?

Defined-benefit pension plans work by an employer guaranteeing a specific amount of retirements to be had if an employee works for a company for a designated amount of time. Both the employer and employee usually contribute to the pension plan, though the employer is the pension plan administrator who manages the fund. When the employee retires (whether they are still with the same company or not), they may file a claim for defined-benefit pension benefits.

How Long Does It Take to Get Vested Under a Pension Plan?

Different entities will have different benefit schedules including when employees are vested. Vesting can be immediate, but it may kick in partially from year to year for up to seven years of employment. If you contribute money to the plan, it's yours if you leave. If your employer kicks in money, it's not all yours until you are fully vested.

Is a Pension Better Than a 401k?

A pension plan is a better retirement vehicle for people who prefer have a guaranteed, defined amount of benefits when they retire. Though employees typically have less control over their money and sacrifice upside earning potential under a pension plan, it is usually a safer option, and the benefits an employee earns is paid out to them for life.

Who Gets a Pension?

To get a pension, an employee has to work for a company that offers a pension plan. This can be a private company, though a majority of pension plans are now offered by government institutions and agencies. In addition, people must often meet a vesting requirement by working for a company for a specific amount of time to quality for pension plan benefits.

The Bottom Line

A pension plan is a retirement vehicle that offers employees the opportunity to earn defined benefits at retirement. Different companies can have different features within their pension plan, but employers often fund a majority of pension plans while guaranteeing employees specific retirement benefits based on their tenure and salary. As opposed to a defined-contribution plan such as a 401(k), pension plans are often defined-benefit where the employee can receive a fixed payment for life once they retire.

Article Sources
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