What Is a Pension?

Pensions Explained in Less Than 4 Minutes

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.

The Balance / Maritsa Patrinos

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, how they work, and what determines pension income for eligible retirees.

Definition and Example of 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.

An employee who receives a pension typically gets a set amount of money per month, each month, for the rest of their lives.

Not every pension adjusts for inflation. If you're entitled to a pension, don't assume that it will include a cost-of-living adjustment.

How a Pension Works

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

The formula that a pension plan uses is typically based on the following factors:

  • Your years of service with the company.
  • Your age.
  • Your compensation.

For example, a pension plan might offer a monthly benefit of 50% of your pay (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, you might be able to work longer and retire at age 65 with 30 years of service. The pension could provide an income of 85% of your pay. More years usually mean more money.

Pension plans must follow specific rules set by the U.S. Department of Labor. These rules state how much a company must place into a pension fund each year to provide their workers with an income when they retire.

Your pension may be subject to a vesting schedule that dictates how much you would get based 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 able to receive a pension. Your company decides in advance what this schedule will be.

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

Taxes on Pensions

Most pension benefits can be taxed. When you begin taking pension income, you'll need to decide whether you should have taxes withheld from your pension payment. If you contributed after-tax money to the pension, that portion of your pension might be tax-free. Some military and government pensions are exempt from taxes if the member was injured on duty. 

Pension Terminations

If your employer offers a pension, they can decide to end it. In that situation, your plan would be frozen. That means you'd get the amount you've earned up to that point. However, you would not be able to build any additional pension income.

Sometimes, pension plans are managed poorly and aren't able to make payments. The Pension Benefit Guaranty Corporation (PBGC) will step in to pay your vested pay, up to the amount allowed by law. The amount you would receive varies according to your age when you retire and whether the plan offers benefits to your spouse if something were to happen to you.

Alternatives to Pensions

The advantage of a pension plan is it provides secure income. Many companies have stopped offering pension plans. That means the burden of saving to retire falls on you. You must figure out how to save enough to create your own pension-like income.

Most pension plans have been replaced by 401(k) plans, which offer a variety of investment choices. Rules allow employers to offer a qualified longevity annuity contract (QLAC) within a 401(k) plan. QLACs can provide secure income to you when you retire. If your company offers this option, you can invest in it to create an income you can count on.

Individual retirement arrangements (IRAs) are another alternative to a pension. They are savings accounts that have tax advantages. You can choose how to invest the funds in your IRA, and some employers match your contributions. 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.