What is a pension and how does it work?

  • A pension is an employer-sponsored retirement plan that guarantees a source of income during retirement.
  • Pensions have become less common among private companies in favor of 401(k) plans, which are less expensive for employers to maintain.
  • The main difference between a traditional pension and a 401(k) is that 401(k)s don’t actually guarantee any retirement benefits.

Retirement is an anxiety-provoking topic for many. In the US, 50% of women and 47% of men between the ages of 55 and 65 have no retirement savings, according to a 2017 census survey.

Retirement planning is represented using the three-legged stool metaphor, with each “leg” representing social security, personal savings, and pensions. “So the idea is that if you have all three, you’re setting yourself up for a good future,” says Chad Parks, founder and CEO of Ubiquity Retirement + Savings and executive producer of the documentary “Broken Eggs: America’s Looming Retirement Crisis.” Joined”.

But over time, the retirement stool is tipping heavily toward the personal savings “leg” as becoming more important, as Social Security isn’t enough to fully support retirees, and pension plans are increasingly scarcer as 401(k)s have become the dominant form. from employer-sponsored retirement plans.

What is a pension?

Pensions are a type of retirement plan in which the employer deposits money during the time the employee is with a company. The amount is calculated based on the employee’s salary history and seniority with the company. Later, when the employee retires, the pension offers a source of guaranteed monthly income until his death.

Some especially generous — and especially rare — pensions even offer survivor benefits, which provide the surviving spouse with a percentage of the pension money owed to the employee.

The type of retirement plan available to you depends on your employer. Many state and local government jobs, such as teachers, still offer traditional pensions. Still, 401(k)s are fast becoming the dominant retirement plan for private companies, though traditional pensions are one of several terms unions may fight over in negotiations.

“You’re probably not going to get [a pension] in a private corporation, or even a publicly traded company,” Parks says. “It’s very hard to find that kind of generosity today.”

How do pensions work?

The value of a traditional pension builds over the time an employee works for an employer, “so the longer you work, the higher your reward,” says Parks. The value of a pension also takes into account the salary of the employee, as well as the expected growth rate of the company.

Once an employee works at a company long enough, they earn their pension, which means they are guaranteed their pension money regardless of their position with the company, even if they are laid off or move companies. Vesting is a gradual process, so if he works for a few years in a company, he can partially vest a pension.

Pensions are usually unfunded or funded: indicating how a company plans to pay the pension. The money for a funded pension comes out of a pool of invested money that the employer sets aside specifically for pensions. Meanwhile, non-funded pensions are paid directly by the company. Entities with unfunded pensions are recognizing that at some point they have to gather the funds to pay the pension, but currently they do not have them on hand.

Parks says that originally the employer paid the pensions in full. However, most modern pension plans incorporate some method for the employee to contribute to the pension “either their own defined contribution to match and increase the pension or, in some cases, they will reduce their paycheck to help fund it,” says Parks.

Are pensions taxable?

Pensions are generally taxed as ordinary income in any

tax bracket

you land in post-retirement. “There’s a joke that they all retired and moved to Florida. Well, there’s a reason why, isn’t there? It’s the weather and there’s also no

income tax

Parks says.

Pension versus 401(k)

Here’s the main difference between pensions and 401(k): A 401(k) is a defined contribution plan in which both the employer and the employee can contribute to the account and invest funds to save for retirement. A pension is an employer-sponsored defined benefit plan that offers benefits based on salary and work history with the company. So, essentially, pensions are plans that employers set themselves up with higher costs and investment risks.

Because pensions are paid primarily by the employer, 401(k)s have become very attractive to companies that want to provide retirement benefits without incurring a high cost. “Corporate America had a big shift in the ’80s, to say, ‘let’s get out of the pension business, but we’ve got to replace it with something.’ That’s when the 401(k) became popular,” says Parks.

The 401(k) is one of several defined contribution plans, which also includes 403(b) plans, employee stock ownership plans, and profit sharing plans. These plans have employees deduct some of their pre-tax income and put it into an investment account. Employers can match an employee’s contribution up to a certain amount.

Unlike a defined benefit plan, nothing is particularly guaranteed in a defined contribution plan because it’s up to the employee to save for retirement. Instead of a guaranteed retirement payout, an employee’s retirement fund is determined by the market and the success of the investments. “‘Definite’ doesn’t really fit here. So it’s a bit of a misnomer,” says Parks.

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