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 compensation1
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.2
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.3
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.4 Some military and government pensions received due to a disability are exempt from taxes.5
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.6
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.7 The maximum amount varies depending on your age at retirement and whether the plan offers survivor benefits.8
Alternatives to Pensions
The advantage of a pension plan is it provides guaranteed income. Unfortunately, many companies have stopped offering pension plans.9 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.10 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.