What Is a Pension Plan, and Should I Have One?
This increasingly rare employee benefit is often worthwhile
A pension plan is an employer-sponsored retirement plan offered in both the public and private sectors that provides income during retirement or upon the termination of a worker's employment. These plans have a storied 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.
If you're among the minority of employees who are eligible to participate in one, understanding how it works and what sets a pension plan apart from a 401(k) plan can help you determine whether it's the right option for you.
Basics of Pension Plans
Traditional pension plans are defined benefit pension plans, which guarantee that employees receive a certain amount upon retirement regardless of their investment’s performance. This ensures that employees receive a predictable income each month once they reach retirement age.
The amount may be a fixed dollar amount multiplied by the number of years they have been in the plan or may be based on a formula that factors in the average of their final years of salary, accrual rate, and length of service.
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 and 401(k) Plan Differences
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.
- 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 contribution to the account. Contributions are usually invested, and the account balance from which the retiree makes withdrawals will reflect any investment gains or losses.
- Your employer funds your pension. With a traditional pension plan, your employer is generally responsible for funding your pension. However, employees 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 the employee to contribute enough to a 401(k) to financially support themselves in retirement.
- A 401(k) gives you more control over investment selection. You direct your own investments in a 401(k) plan, whereas pension contributions are generally invested on your behalf by the company. Employers often enlist investment managers to make investment decisions.
Should I Choose a Pension or a 401(k) Plan?
To put it bluntly, you may not have a choice. With only 14% of Fortune 500 firms offering defined benefit plans in 2019, a 401(k) plan may be your only option. If you work in the public sector (think: military, law enforcement, or public education), you are more likely to have a pension plan; 91% of public-sector workers have access to pension plans compared with only 68% of private-sector workers. However, some companies offer both a pension plan and a 401(k).
Consider enrolling in a 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 the pension plan. This 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 in the plan.
- 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 may not benefit as much from a pension plan because you may not become fully vested.
- You want a future-proof retirement savings option. Pension plans are subject to freezes, which prevent new enrollees in the plan, 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.
The number of top employers offering pension plans is declining, but roughly nine out of 10 public-sector employers still provide them.
How Should I Plan for Retirement With a Pension Plan?
The three pillars of retirement income are Social Security, personal savings (such as traditional and Roth IRAs), and employer pensions, which have morphed more recently into 401(k) plans. To determine how your pension fits into your overall retirement income, you'll need to do some research about your pension plan benefits.
First, identify what pension plan criteria you need to meet to maximize your payouts. Then, get to know how much you are eligible to receive from your pension plan based on the information in the plan document. Plug your estimated pension benefit along with your Social Security benefit and existing savings into a retirement calculator such as the Vanguard Retirement Calculator to determine whether you are on track for your retirement income goals.
If you're lagging, adjust your retirement savings accordingly. For example, boost your savings through a traditional IRA or a Roth IRA, which would allow you to contribute up to $6,000 per year in 2020 and 2021 ($7,000 if you're 50 or older).
Is a Pension Plan a Good Option?
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. Not all plans are equal, and your career choices may make it impractical to participate.
If, however, you are willing to work at a company long enough to reap the benefits, a pension plan is a valuable benefit. These plans provide guaranteed income in retirement, which you can't get from a 401(k) plan.
If you participate in a pension plan, understand the specific details related to your plan. Employers often host workshops on what the plan offers or 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 retire comfortably.
Pension Benefit Guaranty Corporation. "History of PBGC." Accessed Nov. 9, 2020.
Social Security Office of Retirement and Disability Policy. "Contributory Retirement Saving Plans: Differences Across Earnings Groups and Implications for Retirement Security." Accessed Nov. 9, 2020.
Congressional Research Service. "Worker Participation in Employer-Sponsored Pensions: A Fact Sheet," Pages 1–2. Accessed Nov. 9, 2020.
U.S. Department of Labor. "Types of Retirement Plans." Accessed Nov. 9, 2020.
Investor.gov. "Employer-Sponsored Plans." Accessed Nov. 9, 2020.
Willis Towers Watson. "Retirement Offerings in the Fortune 500: 1998 – 2019." Accessed Nov. 9, 2020.
IRS. "Retirement Topics - Vesting." Accessed Nov. 9, 2020.
The Wharton School of the University of Pennsylvania. "GE’s Pension Freeze: Will It Help — or Hurt?" Accessed Nov. 9, 2020.
Social Security Office of Retirement and Disability Policy. "Social Security Retirement Benefits and Private Annuities: A Comparative Analysis." Accessed Nov. 9, 2020.
IRS. "Income Ranges for Determining IRA Eligibility Change for 2021." Accessed Nov. 9, 2020.