What Is a Pension?

Definition & Examples of a Pension

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Image shows a little man standing next to a jar of coins that's larger than him and a large calendar next to him. Text describes alternatives to pension plans, which are in the article.
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A pension is a retirement plan that provides a monthly income. The employer bears all of the risk and responsibility for funding the plan. Learn more about pensions and how they work.

What Is a Pension?

With a pension, your employer guarantees you an income in retirement. Employers are responsible for both funding the plan and managing the plan's investments. Not all employers offer pensions, but government organizations usually do.

How a Pension Works

A formula determines how much pension income you will receive once you are retired.

The formula a pension uses is typically based on a combination of the following:

  • Your years of service with the company offering the pension
  • Your age
  • Your compensation

For example, a pension plan might offer a monthly retirement benefit that replaces 50% of your compensation (based on an average of your pay over your last three years of service) if you retire at age 55 and have at least 10 years of service.

With that same pension, if you work longer and retire at age 65 and have 30 years of service, the pension might provide a retirement benefit that replaces 85% of your compensation. More years usually means more money.

Pension plans must follow specific rules set by the Department of Labor. These rules specify how much the company must put away each year into an investment fund to provide you with a defined pension amount in the future.

Your pension benefits may be subject to a vesting schedule, which is an incentive program that determines how much you would get depending on how long you've been with the company.

For example, you may have to work for the employer a minimum of five years before you would be eligible to receive a pension. Your company determines in advance what this schedule will be.

If you are in a pension plan that allows employee contributions, your contributions are vested immediately.

Taxes on Pensions

Most pension benefits are taxable. When you begin taking pension income, you'll need to determine if you should have taxes withheld from your pension payment. If you contributed after-tax money to the pension, that portion of your pension may be tax-free. Some military and government pensions received due to a disability are exempt from taxes. 

Pension Terminations

If your employer offers a pension, they can decide to terminate it. In this situation, your accrued benefit usually becomes frozen, which means you'll get whatever you've earned up to that point, but you cannot accumulate any additional pension income.

If a pension plan is managed poorly and isn't able to pay out all of the promised benefits, the Pension Benefit Guaranty Corporation (PBGC) will step in to pay your vested benefits up to the maximum amount allowed by law. The maximum amount varies depending on your age at retirement and whether the plan offers survivor benefits.

Alternatives to Pensions

The advantage of a pension plan is it provides guaranteed income. Unfortunately, many companies have stopped offering pension plans. This means the burden of saving for retirement falls on you. You must figure out how to save enough to create your own pension-like income in retirement.

Most pension plans have been replaced by 401(k) plans, which offer a variety of investment choices. Most 401(k) plans don't offer a way to invest in something that provides guaranteed income. Rules do allow employers to offer a qualified longevity annuity contract (QLAC) within a 401(k) plan.

QLACs can provide guaranteed income to you in retirement. If your company offers this option, you can invest in it to create a guaranteed income for your retirement.

Individual retirement arrangements (IRAs) are another alternative to a pension. They are essentially savings accounts with tax advantages. You can choose how to invest the funds in your IRA. You can contribute to an IRA even if you have a pension, though your deductions may be limited if you opt for a traditional IRA.

Key Takeaways

  • A pension is a retirement plan that provides a monthly income in retirement. 
  • Unlike a 401(k), the employer bears all of the risk and responsibility for funding the plan.
  • A pension is typically based on your years of service, compensation, and age at retirement. 
  • 401(k)s, qualified longevity annuity contracts, and IRAs can serve as alternatives to pensions. 

Article Sources

  1. U.S. Department of Labor. "Types of Retirement Plans." Accessed July 25, 2020.

  2. Department of Labor. "What You Should Know About Your Retirement Plan," Page 4. Accessed July 25, 2020.

  3. Department of Labor. "FAQs about Retirement Plans and ERISA," Page 4. Accessed July 25, 2020.

  4. Internal Revenue Service. "Topic No. 410 Pensions and Annuities." Accessed July 25, 2020.

  5. Internal Revenue Service. "Publication 575 (2019): Pension and Annuity Income," Page 6. Accessed July 25, 2020.

  6. Department of Labor. "What You Should Know About Your Retirement Plan," Page 6. July 25, 2020.

  7. Department of Labor. "FAQs about Retirement Plans and ERISA," Page 12. Accessed July 25, 2020.

  8. Pension Benefit Guaranty Corporation. "Your Guaranteed Pension: Single-Employer Plans." Accessed July 25, 2020.

  9. Social Security Administration. "The Disappearing Defined Benefit Pension and Its Potential Impact on the Retirement Incomes of Baby Boomers." Accessed July 25, 2020.

  10. Department of the Treasury. "Treasury Issues Final Rules Regarding Longevity Annuities." Accessed July 25, 2020.

  11. IRS. "IRA Deduction Limits." Accessed July 25, 2020.