What Is a Pension Plan?

Pension Plans Explained

Planning our retirement together
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A pension plan is a type of employer-sponsored retirement plan that pays employees a set income during retirement, usually based on how long they worked for the company. These plans are becoming less common as more employers offer 401(k) retirement plans.

Unlike a 401(k), a pension plan is not funded by taking money out of an employee's paycheck. Instead, the employer invests money in a pension plan fund, which is then paid to employees upon retirement.

If you're among the minority of employees who are covered by an employer-sponsored pension plan, understanding how it works can help you maximize your benefit and obtain a valuable source of retirement income.

What Is a Pension Plan?

A pension plan is an employer-sponsored retirement plan that provides income during retirement or upon the termination of a worker's employment. These can be offered in both the public and private sector, though they are becoming less common in the private sector.

Under a pension plan, employees receive a set income during retirement that is related to how long they worked at the company. The income is funded by the employer rather than the employee.

Pension plans have a history dating back to 1875, when the first corporate pension plan was established in the United States at the American Express Company. Since the 1980s, however, pension plans have been gradually phased out and replaced with 401(k) plans.

How a Pension Plan Works

Traditional pension plans are defined-benefit pension plans, which guarantee that employees receive a certain amount upon retirement regardless of their investment’s performance. That ensures that employees will receive a predictable income each month after they reach retirement age.

How the amount is calculated can vary among plans. Usually, the value of a pension is determined by how long an employee was with the employer before retiring.

A pension may pay a fixed dollar amount multiplied by the number of years the employee has been participating in the plan or based on a formula that factors in the average of their final years of salary, accrual rate, and length of service.

Unlike a 401(k) plan, a pension plan is not funded out of an employee's paycheck. Instead, the employer is responsible for contributing to the investments that fund their available pension plan. However, employees may have the option to contribute as well.

Private-sector defined-benefit pension plans are generally insured to a certain extent by the Pension Benefit Guaranty Corporation (PBGC). Consult the "summary plan description" for your plan to verify that it is covered by PBGC.

Pension Plan vs. 401(k)

These two employer-sponsored retirement plans are sometimes confused because 401(k) plans may be referred to as defined-contribution pension plans. However, there are clear distinctions between them.

 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

No Guaranteed 401(k) Benefit

A 401(k) is a defined-contribution plan. Unlike a defined-benefit plan, this plan type doesn't guarantee employees any form of payment in retirement.

Employees contribute a certain percentage of their earnings to an account created by the employer, and employers can contribute a partial or full match of the employee's contribution to their account.

Contributions are usually invested, and the account balance from which the retiree makes withdrawals will reflect any investment gains or losses.

Employer Funds Pension

With a traditional pension plan, your employer is generally responsible for funding your pension. However, employees who are enrolled in pension plans may elect or be required to contribute to the plan.

While a 401(k) may offer an employer match, the onus is on employees to contribute enough to a 401(k) to support themselves in retirement.

Investment Selections

A 401(k) gives you more control over investment selection. You direct your own investments in a 401(k) plan.

Pension contributions are generally invested on your behalf by the company. Employers often enlist investment managers to make investment decisions.

Do I Need a Pension Plan?

You likely don't have a choice about the type of retirement plan available to you. With only 14% of Fortune 500 firms offering defined-benefit plans, a 401(k) plan may be your only option. If your employer does happen to offer a pension plan, it is likely that you will be automatically enrolled based on a defined set of criteria, such as reaching a certain length of service. In addition, while rare, some employers who offer a pension plan may also offer the ability to enroll in a 401K plan, giving you the best of both worlds.

If you work in the public sector (such as 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 workers have access to DB pension plans, compared with only 15% of private-sector workers. However, some companies that offer both a pension plan and a 401(k) may require you to choose one or the other. Consider enrolling in a DB pension plan if:

  • You need income security in retirement. If you have limited fixed sources of income in retirement, the guaranteed income provided by a defined-benefit pension plan may be extremely appealing. With a 401(k), there's no limit on how much your account can grow—or decline—in value. If it declines enough, you could outlive your balance.
  • You intend to stick with the same company for the long haul. If you intend to spend several years or even your entire career at one company, it may make sense to participate in its pension plan. That is because you are more likely to become fully vested in the plan, which would entitle you to use all of the benefits that you accrue.
  • You don't plan on moving. If the employment that makes you eligible for a pension plan is location-dependent—for example, if you work as a teacher, and the state runs the retirement plan—it may make sense to choose the pension as you will likely keep working in the same state.

You may want to enroll in a 401(k) instead if:

  • You want a tax-advantaged option. A traditional 401(k) plan allows you to contribute pre-tax dollars from your paycheck to the plan, which reduces your taxable income. This strategy may be desirable if you are currently in a higher income tax bracket and expect to be in a lower tax bracket in retirement.
  • You plan to switch companies often. If you work in the private sector or plan to work for several public-sector organizations over the course of your career, you might not benefit as much from a pension plan, because you might not become fully vested.
  • You want a future-proof retirement savings option. Pension plans can be subject to freezes, which prevent new enrollees from joining them, and buyouts, whereby employers offer a lump-sum payment to reduce the financial burden of long-term payouts. In contrast, 401(k) plans are replacing these plans, so they are poised to remain a viable retirement savings option.

If your employer doesn't offer any kind of retirement plan, take charge of your own savings through a traditional IRA or a Roth IRA. That will allow you to contribute up to $6,000 per year in 2020 and 2021 ($7,000 if you're age 50 or older).

If your employer is among the minority that offers pension plans, do your homework about the plan before you jump at the chance to enroll.

If you participate in a pension plan, understand the specific details related to it. Employers often host workshops on what the plan offers, or they will go over the specifics of the plan during orientation. If you are unsure of the plan that you are getting, your employer match, or anything else pertaining to the plan, talk to a human resources representative at your organization.

Once you know what to expect from the pension plan, evaluate it alongside other retirement income sources, and change your savings strategy as needed to increase your likelihood of retiring comfortably.

Key Takeaways

  • A pension plan is a type of employer-sponsored retirement plan that pays employees a set income during retirement, usually based on how long they worked for the company.
  • These plans are becoming less common as more employers offer 401(k) retirement plans.
  • Employers are responsible for funding traditional pension plans. However, employees who are enrolled in pension plans may elect or be required to contribute.
  • Pension plans can benefit private-sector employees who plan to stay with a company long-term, and public-sector employees who plan to stay in the same location to remain eligible for a state-sponsored pension.