DEFINITION:
(Tiny Tips) – A pension plan is a type of employer-sponsored retirement plan that typically pays retired employees a fixed income based on their years of service with the company. As more employers offer 401(k) retirement plans, these plans are becoming increasingly rare.
Key Takeaways
- A pension plan is a type of employer-sponsored retirement plan that typically pays retired employees a fixed income based on their years of service with the company.
- As more employers offer 401(k) retirement plans, these plans are becoming increasingly rare.
- Employers are responsible for funding traditional pension plans. However, employees enrolled in a retirement plan may elect or be required to make contributions.
- Pension plans can benefit private sector employees who want to stay with the company for the long term and public sector employees who want to stay in the same place and continue to be eligible for government-sponsored pensions.
Pension Plan Definition and Examples
Pension plans are employer-sponsored defined benefit retirement plans that provide income during an employee’s retirement or termination of employment. These can be provided in both the public and private sectors, although they are increasingly less common in the private sector.
Notes
Unlike a 401(k), a retirement plan is typically not funded through deductions from an employee’s paycheck. Instead, employers invest the money in a pension fund and then pay it out to employees as a defined benefit when they retire. Some plans may also require or provide the option for employee contributions.
Under a pension plan, retired employees receive a fixed income based on the time they have worked with the company. Income is funded by the employer, not the employee.
The history of pension plans can be traced back to 1875, when American Express established the first corporate pension plan in the United States. Since the 1980s, however, pension plans have been phased out and replaced by defined contribution plans such as 401(k)s.
This is How Pension Plans Work
Traditional pension plans are defined benefit pension plans that guarantee employees a certain amount of money when they retire, regardless of how their investments perform. This ensures employees receive a predictable monthly income once they reach retirement age.
How the amount is calculated may vary by plan. Typically, the value of a pension depends on how long the employee worked for the employer before retiring.
An annuity can be a fixed amount multiplied by the number of years the employee has been in the plan, or it can be calculated based on a formula that takes into account the average of the employee’s last years of pay, accrual rate, and years of service.
Notes
Private sector defined benefit pension plans are typically insured to some extent by the Pension Benefit Guaranty Corporation (PBGC). Please see your plan’s “Summary Plan Description” to verify whether it is covered by PBGC.
There are still a handful of companies that offer retirement plans. These companies include Coca-Cola, General Mills and American Airlines. However, only certain employees are eligible to participate in a pension fund. These are usually employees who have been with the company for a long time.
Pension Plans and 401(k)s
There are clear differences between a traditional defined benefit plan and a 401(k) defined contribution plan.
PENSION PLAN | 401(K) |
---|---|
Guarantees employees a benefit in retirement. | Does not guarantee employees a retirement benefit. |
Funded by employer. | Employees contribute a portion of their paycheck to an investment plan |
Employee may be required or may choose to contribute as well. | May include employer match, up to a certain percentage. |
Rarely offers employees control over investment options. | Employees may choose among available investment options. |
401(k) benefits not guaranteed
A 401(k) is a defined contribution plan. Unlike defined benefit plans, these plans do not guarantee employees a payment upon retirement.
Employees deposit a percentage of their earnings into an account set up by the employer, into which the employer may deposit some or all of the employee contributions.
Contributions are typically invested, and retiree withdrawals from the account balance reflect any investment gains or losses.
Employer pension fund
With a traditional pension plan, your employer is usually responsible for funding your pension. However, employees enrolled in a retirement plan may make voluntary or required contributions to the plan.
While a 401(k) may provide an employer match, it is the employee’s responsibility to contribute to the 401(k) to support their own retirement.
Investment options
A 401(k) gives you more control over your investment choices. You have control over what you invest in your 401(k) plan.
Pension contributions are usually invested by a company on your behalf. Employers often hire investment managers to make investment decisions.
Do I need a pension?
You may not be able to choose the type of retirement plan that’s right for you. Since only 14% of Fortune 500 companies offer defined benefit plans, a 401(k) plan may be your only option. If your employer does offer a retirement plan, you may be automatically enrolled for a certain number of years of service based on established criteria, such as achievement.
Additionally, while it’s rare, some employers that offer retirement plans may also offer the option to join a 401(k) plan, giving you the best of both worlds.
If you work in the public sector (such as the military, law enforcement or public education) you are more likely to have a defined benefit (DB) pension plan. As of 2020, 86% of public sector employees had access to a DB retirement plan, compared with just 15% of private sector employees. 3 However, some companies that offer both a pension plan and a 401(k) may require you to choose one or the other. If you meet any of the following criteria, consider joining a Database Retirement Plan.
You need income protection in retirement
If you have limited sources of fixed income in retirement, the guaranteed income of a defined benefit pension plan can be very attractive. With a 401(k), the value of your account can rise or fall without limit. If it decreases enough, you may exceed equilibrium.
You plan to stay with the same company for a long time
If you plan to spend several years or even your entire career with a company, it might make sense to participate in its retirement plan. This is because you are more likely to be fully eligible for the scheme, which will entitle you to use all the benefits you are entitled to.
You don’t plan to move
If the job that qualifies you for a pension depends on location—for example, if you work as a teacher and the state administers the pension—it may make sense to choose the pension because you may continue to work in the same state.
If you meet any of the following criteria, you may want to join a 401(k).
You want a tax-deferred option
With a traditional 401(k) plan, you contribute pre-tax funds to the plan from your paycheck, thereby reducing your taxable income. This strategy may be ideal if you are currently in a higher income tax bracket and expect to be in a lower tax bracket when you retire.
You plan to change companies frequently
If you work in the private sector or plan to work for multiple public sector organizations throughout your career, you may not benefit as much from a retirement plan because you may not achieve full vesting.
You want a pension that’s future-proofed
Pension schemes may be frozen, preventing new members from joining, or they may introduce buyouts, where employers provide a lump sum payment to ease the financial burden of long-term withdrawals. In contrast, 401(k) plans replace these plans, so they may still be viable retirement options.
Notes
If your employer doesn’t offer a retirement plan, manage your savings yourself through a traditional IRA or Roth IRA. This allows you to contribute up to $6,000 each year in 2021 and 2022, depending on your income level ($7,000 if you are 50 or older).
If your employer is one of the few that offers a retirement plan, do your homework on the plan before joining one.
If you participate in a retirement plan, you should understand the specific details involved. Employers often host workshops about the program’s offerings or discuss the program’s details during orientation. If you are unsure about which plan you will receive, whether your employer is the right fit for you, or any other information related to this plan, please contact your organization’s human resources representative.
Once you know what to expect from retirement savings, compare it to other sources of retirement income and modify your savings strategy as needed to increase the likelihood of a comfortable retirement.
Tiny Tips uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles.
- Pension Benefit Guaranty Corporation. “History of PBGC.” Accessed Nov. 28, 2021.
- Social Security Office of Retirement and Disability Policy. “Contributory Retirement Saving Plans: Differences Across Earnings Groups and Implications for Retirement Security.” Accessed Nov. 28, 2021.
- Congressional Research Service. “Worker Participation in Employer-Sponsored Pensions: A Fact Sheet,” Pages 1–2. Accessed Nov. 28, 2021.
- Pensions and Investments. ” General Mills to freeze U.S. pension plans at the end of 2027.”
- Sovereign Wealth Fund Institute. “Coca-Cola Pension Plan (Coca-Cola Pension Plan).”
- U.S. Department of Labor. “Types of Retirement Plans.” Accessed Nov. 28, 2021.
- Investor.gov. “Employer-Sponsored Plans.” Accessed Nov. 28, 2021.
- Willis Towers Watson. “Retirement Offerings in the Fortune 500: 1998 – 2019.” Accessed Nov. 28, 2021.
- Internal Revenue Service. “Retirement Topics – Vesting.” Accessed Nov. 28, 2021.
- Internal Revenue Service. “Retirement Topics – IRA Contribution Limits.” Accessed Nov. 28, 2021.