Pensions are retirement plans that provide income for employees after they retire. Employers, employees or both may contribute depending on the specifics of the pension.
Pensions have become less common in the private sector despite their appeal to employees. However, the majority of public sector employees still have access to pensions. Let’s delve into the details of pension plans and how they operate.
What is a pension?
The term “pension” typically refers to a defined-benefit plan. Pensions have a long history in the United States, with the first employer-provided pension plan established by the American Express Company in 1875. By 1987, there were over 232,000 private pension plans covering around 40 million employees.
While defined-benefit plans are popular with employees, they can be expensive to establish and maintain. This has led to the rise in popularity of defined-contribution plans, such as the 401(k) and 403(b) plans.
While many private-sector employers have shifted to defined-contribution plans, most public-sector employees still participate in defined-benefit plans. Approximately 80 percent of public sector employees are part of these plans.
Understanding how pensions work
Employers offering defined-benefit plans contribute money to a fund for employees, which is then invested to grow over time. When eligible employees retire, they receive regular fixed payments for life, similar to an annuity. This payment is not dependent on investment performance.
Pension can also refer to a defined-contribution plan, like a 401(k) or 403(b). Employees regularly contribute to these plans through payroll deductions. Employers may provide matching contributions up to a certain percentage of compensation or a flat dollar amount. However, with a defined-contribution plan, the responsibility of contribution is not solely on the employer.
Regardless of the retirement plan, these funds provide income to eligible employees and offer tax advantages to encourage investment by employers and employees.
Like other retirement plans, pensions have vesting schedules, where ownership in the account is gradually gained. There are two types of vesting schedules: cliff vesting and graded vesting.
Cliff vesting schedule
A cliff vesting schedule takes an all-or-nothing approach. If you leave your job before being fully vested, you won’t receive any pension benefits. However, if you wait until you are fully vested, you will receive the full amount. A cliff vesting schedule typically ranges from one to five years.
In some cases, missing out on retirement benefits can mean forfeiting a significant sum of money. A pension calculator can help estimate the amount you will receive.
Graded vesting schedule
Graded vesting allows you to be eligible for some retirement benefits even if you leave your job before being fully vested. You may be entitled to a higher percentage of your full retirement benefit for every year or two of service.
For example, with a six-year graded vesting schedule, you might receive 0 percent after the first year, 20 percent after the second year, 40 percent after the third year, etc. After six years, you would be 100 percent vested.
Graded vesting schedules vary by employer. Employees who leave their jobs before retirement may sometimes receive a lump sum upon departure. In other cases, it may be necessary to wait until retirement to receive the funds, either as monthly payments or a lump sum (which can be invested in an annuity for guaranteed income). Penalties may apply if taking a lump sum before retirement.
Types of pension plans
The two most widely known types of pension plans are defined-benefit and defined-contribution plans. However, government pensions also have unique features worth discussing.
Defined-benefit pension plan
Employees with defined-benefit plans receive monthly payments for life or a lump sum upon retirement. The employer typically provides most of the funding. If the pension plan cannot cover the full amount, the employer must make up the difference, which can be a financial burden if investments underperform.
Defined-contribution pension plan
Defined-contribution plans include 401(k), 403(b), and 457(b) plans. These plans vary based on the type of employer, but employees contribute a significant portion of the funding. Employers often match contributions up to a percentage of compensation or a set dollar amount.
Employees can start taking distributions from a defined-contribution plan without penalties after reaching age 59½. While there is no requirement to withdraw a specific amount from these plans, required minimum distribution (RMD) rules apply. Defined-contribution plans are favorable for employers as employees withdraw money from their accounts rather than receiving guaranteed monthly payments in retirement.
Government pensions
Government pensions are similar to private-sector pensions, but government employees may contribute to their defined-benefit plans alongside their employers. Additionally, government pensions may include plans like the Thrift Savings Plan (TSP), which are defined-contribution plans with potentially more generous matching contributions than private-sector equivalents.
Advantages of pensions
There are several advantages of pensions that make them appealing to employees.
- Guaranteed income: Pensions offer guaranteed income to employees who choose monthly payments, simplifying retirement planning and supplementing Social Security benefits.
- Employer funded: Pensions are typically funded entirely by the employer, allowing employees to enhance their retirement savings without reducing their paychecks. Employee contributions often come with tax benefits.
- Some investment control: With defined-contribution plans, employees may have some control over their investment choices, considering their risk tolerance and time horizon.
- COLA: Some pension plans provide cost of living adjustments (COLA), which can be valuable for employees with long retirements.
Risks of pensions
Despite the benefits, pensions come with certain risks for employees.
- Employer dependence: If the employer faces financial challenges or goes bankrupt, the pension fund could be at risk. While protections exist, employees may not receive the full amount in such scenarios.
- No individual control: Employees have limited control over how pension funds are invested, unlike in defined-contribution plans where they can benefit from market gains. Regardless of market performance, pension income remains the same. However, this guarantees income regardless of market conditions.
- Value depreciation: If a pension plan lacks COLAs, the value of retirement income may decrease over time.
Bottom line
With defined-benefit pension plans, employers set aside funds in an invested pool of money. Retiring employees receive either a lump sum or guaranteed monthly payments for life, independent of investment performance.
Defined-contribution plans like 401(k) or 403(b) involve employee and employer contributions, with employees selecting their investments and receiving retirement income based on their savings and investment growth. Both pension plan types have their advantages and disadvantages, but they can complement Social Security benefits.