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What Is a Pension Plan?

Pension plans are employer-sponsored programs that give you guaranteed income after you retire. We explain how they work in this article.

When you work at a company or with the government, chances are that you’ll have some type of retirement plan available to you. In the case of some companies, this may be a 401(k) or a similar defined contribution plan. However, others may offer a defined benefit pension plan. This is a fund that you automatically contribute to and, in return, provides income once you retire.

This article will help you understand how pension plans work and where they fit into your retirement plans. You’ll also learn about the downsides of these types of plans. Finally, we’ll break down its impact on taxes and your social security payments.

How Pension Plans Work

At its core, a pension plan is a large fund that provides employees of a firm retirement benefits. This may come in the form of a lump sum or a series of payouts that extend for years. As you work for an employer that offers this type of plan, they’ll regularly contribute to the fund and invest. Some employers also allow employees to make contributions and may even match them.

It’s important to note that your employer will take on all the investment responsibility and risk. Pensions are institutional investors that pick and choose what to invest in to grow the fund. Most often, funds develop a diversified portfolio that may include any one of the following:

Typically, you must work at an organization for several years before you can earn a pension. Government organizations and companies often refer to this as the vesting period. The length can vary, but for many state employees, including those in California, it takes five years for pensions to vest. At Boeing, the world’s largest aerospace manufacturer, it takes ten years of service to be able to take your benefits in full, but five years for cliff vesting and seven years for graded vesting.

Your benefits are usually pre-defined ahead of time; however, several factors go into what your final income will be. This includes details like your age, salary, and tenure. Often, employers will take the average of your last five years of salary and multiply it by a percentage, as well as your overall tenure.

Below is an example of what that calculation may look like in practice:

Illustration of pension calculation.

Types of Pension Plans

There are two major types of pension plans – a defined-benefit plan and a defined contribution plan. Each one builds toward an employee’s retirement but differs in how benefits are received and contributed throughout their tenure.

Defined Benefit Plan

A defined benefit or traditional pension plan is one where an employer pays an employee a set amount of income after they retire. In this arrangement, the employer shoulders all the risk and responsibility for funding the plan, rather than a defined contribution plan, where the employee must pay portions of their monthly check. Additionally, the employer invests money to grow the fund, but any losses will not decrease what an employee receives.

For an employee to receive their guaranteed benefits after retiring, they must work at the company for a certain period until the pension vests. This varies from company to company, but, as mentioned, it can take anywhere from five to ten years.

Defined Contribution Plan

With a defined contribution plan, employees make contributions from each paycheck. Then, the employer will typically match this amount. Unlike a defined benefit plan, it is up to the employee to invest the funds in the account to grow it over time with compound interest. An example of this arrangement is a 401(k).

Pros and Cons

Pension plans are well-regarded because they typically provide retirees with income that lasts for the remainder of their life. However, as with any other retirement plan, this arrangement isn’t without some risk. For instance, your benefits are at the mercy of your employer’s investment strategies and financial health.

Below, we break down the specific advantages and disadvantages:

Pros

  • Provides guaranteed income for retirees
  • Employer shoulders investment and contribution responsibility
  • Payments are based on your salary

Cons

  • If the company goes bankrupt, you may lose your pension
  • Until you retire, you have no way of withdrawing or receiving any of your benefits
  • Since your employer shoulders all of the investment responsibility, you have no say in how they manage the fund

How Pensions Are Taxed

Pension benefits from qualified employer retirement plans are subject to federal income taxes. You’ll need to pay to begin paying as soon as you start receiving benefits. However, they can be either fully or partially taxable depending on how funds were contributed to the plan.

If you didn’t contribute any after-tax money or your employer didn’t automatically withhold funds from your pay, your pension is fully taxable. For your payments to only be partially taxable, you’ll need to have contributed after-tax dollars to the account. Additionally, if your benefits begin after November 18, 1996, you must use the Simplified Method to determine how much you owe.

In the case of a defined-contribution plan, such as a 401(k), your earnings are also tax-deferred. Once you begin drawing from the account, you must pay federal income taxes. And, if you receive payments before 59.5 years old (55 if you leave your job in the same year), your funds are subject to a 10% penalty.

Impact on Social Security Payments

While a pension may provide a guaranteed income upon retirement, it can also cut into your Social Security earnings if your employer doesn’t pay Social Security taxes. This is commonly referred to as the Windfall Elimination Provision (WEP). Typically, this situation applies to government workers or those who work abroad.

If you’re receiving a pension, you should always be aware of the Government Pension Offset (GPO) program. The GPO program modifies Social Security spousal or widower benefits if you receive benefits from a non-covered plan. These are pensions in which the employer doesn’t withhold Social Security taxes, as mentioned in the last paragraph.

Keep in mind that if you worked for other employers that did withhold Social Security taxes throughout your career, you’ll still be eligible to receive benefits. If you work for 30 or more years while paying these taxes, your government payments won’t see any reduction.

How Pensions Fit into Your Retirement Plan

If you have the opportunity to receive a pension, chances are it will be a focal point of your retirement. However, an effective retirement plan typically utilizes several investment and savings vehicles at once, along with Social Security, to help you replace your paycheck and live comfortably. In other words, since a pension typically pays a portion of your highest five years of earnings, it makes sense to try and add additional income sources once you retire.

Jung Seh, CFP and financial advisor at Bogart Wealth, explains that you should think about “all the retirement income sources you will have such as a DB plan, DC plan, IRA, Roth IRA, social security, or after-tax savings.” Then ask yourself, “How much will [I] need to replace [my] paycheck?” Other important considerations to make are “tax implications,” and “when you should start each income source.”

She continues that “IRA, Roth IRA, annuity, and insurance are some vehicles one could use for retirement income in addition to the employer-provided plans.” However, managing all of these vehicles can be tough for one person. It may be wise to speak with a financial advisor, such as a Certified Financial Planner (CFP) or Chartered Financial Consultant (ChFC), to properly plan for retirement.

As you search for a finance professional, be sure to look for high-quality individuals who adhere to a fiduciary duty. To help you search for an advisor, consider using this free matching tool, which will help you find up to three vetted options near you.

Frequently Asked Questions

How do pension plans pay out?

You’ll typically receive your benefits in the form of monthly payments. The amount you receive is largely dependent on salary, tenure, position, and age.

Can a pension plan be rolled over to an IRA?

It’s possible to roll your pension over to your traditional or Roth IRA. However, your employer must allow this to occur and the plan must be “qualified” by the IRS. And, because pensions get their funding from pre-tax dollars, you’ll need to pay a substantial amount of taxes once you make the transition.

What does it mean to be vested in a pension plan?

When you’re vested, you’re eligible to receive benefits once you retire, even if you leave the organization.

Can you have a 401(k) and a pension plan?

Yes, it’s possible to have both a 401(k) and a pension. In one scenario, you could have both accounts if your employer offers them. Alternatively, a past employer may have offered one plan, while a new one offers another. In this case, it would make sense for you to have both.

What happens to my pension if the company I work for goes bankrupt?

In the case of bankruptcy, you and every other employee will automatically become vested in the benefits you have already accrued. Typically, the Pension Benefit Guaranty Corporation will also insure your benefits up to a certain coverage limit.

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