What is a Pension and How Does it Work?
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Summary:
A pension is a form of a retirement plan that guarantees certain benefits based on employment history. It is different from a 401(k) because the employer, rather than the employee, contributes to the fund. Pensions are most common in stable, large employee pools such as government jobs, unions, and state-sponsored positions.
Whether retirement is around the corner or a long way off, it’s never too early to start planning for it. Fortunately, many jobs have retirement plans in place so you can start saving early. Two of the most common retirement plans are pensions and 401(k)s.
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What is a pension?
A pension is a retirement fund that is financed largely or wholly by an employer and is managed by the employer rather than an independent financial institution. Pensions used to be much more common than they are today and have largely been replaced by 401(k) plans and IRAs that are more stable, predictable, and don’t require the same levels of management and risk as traditional pensions.
In this article, we get into the nitty-gritty of what pensions are, what they aren’t, the difference between a pension and a 401(k), and the risks and advantages associated with pensions.
Pension vs. 401(k)
Pensions and 401(k)s are the two most common types of retirement plans in America today. The biggest difference between a pension and a 401(k) is who manages the funds and how they are dispersed when an employee retires.
401(k)s
A 401(k) is a fund operated by an independent financial institution and builds interest over time. However, a 401(k) is funded entirely or mostly by the employee, not the employer. While your employer may match your retirement contributions up to a certain percentage, employer contributions are not required.
Typically, a 401(k) uses basic market products such as low-risk stocks and bonds to generate consistent interest gains that are relatively stable over time. A 401(k) is also tax-deferred, which means that you don’t pay taxes on the income until you withdraw it. Though most 401(k) plans allow you to withdraw funds before you retire, these withdrawals come with penalties that may not make the withdrawals worth it.
Pensions
A pension is structured differently from a 401(k) and comes with its own advantages and disadvantages. Unlike a 401(k) that’s funded by an employee and has a fluctuating value based on how the products in the fund perform in the market, a pension is funded by the employer.
A pension is a predetermined set of benefits an employee can expect when they retire based on factors like how many years they have worked for the company and how much they earned while working there. The employer is responsible for making sure the fund is healthy and performing well enough to ensure that the predetermined pension benefits can be paid to retiring employees.
Two types of pensions
There are two types of pension structures employers can set up for their employees: a defined-benefit plan and a defined-contribution plan. Both have their risks and benefits based on factors such as market performance and asset liability.
Defined-benefit plan
A defined-benefit pension is a plan that guarantees a payout of benefits based on a predetermined formula. For instance, if an employee works for 10 years and makes a particular salary during that time, they will receive a set amount of money (determined by a formula) from a defined-benefit pension plan when they retire.
Defined-benefit plans can be either distributed directly from the employer or accrued by contributions to a fund that mature over time.
Defined-contribution plan
A defined-contribution pension can be a combination of regular payments from the employee’s salary or from the employer directly. In this case, contributions are guaranteed but the final value of the retirement package is determined in part by market forces and financial management.
The employer agrees to make regular contributions to the pension fund based on the employee’s predicted benefits. However, the final value is dependent, to some extent, on fund performance.
If you need some assistance planning your retirement fund, you may want to speak with an investment advisor.
Can companies change pension plans?
In general, it is lawful for companies to alter certain pension benefits, provided they don’t violate anti-cutback guidelines. Protected pension items are things like accrued benefits and early retirement bonuses, but payout timelines and benefits being paid out are fair game as long as they don’t alter benefits that are currently owed.
Distribution of retirement income
For defined-benefit plans, you have a couple of choices regarding how you can receive your retirement income. You can take a lump sum distribution, a monthly annuity payment, or a combination of the two.
- Lump sum distribution. Some pensions pay out the entirety of the retirement benefits in one large sum upon retirement. Pensioners may still be eligible for other benefits such as health care.
- Monthly annuity. A more typical pension plan is a fixed monthly payout for the remainder of the employee’s life. However, you do run the risk of running out of pension funds, which the Pension Benefit Guaranty Corporation may help with (to a certain extent).
Which distribution option is best?
This depends on the employee. Some pensions allow employees to decide whether they would like a monthly annuity or a lump sum. If an employee feels they are able to better manage their pension themselves, they may take a lump sum. However, if an employee prefers to have their finances managed for them by the program, they may opt for a monthly annuity.
Employees may choose one or the other based on the perceived health of the pension itself or market conditions that are not currently favorable to pension maintenance.
Pension Benefit Guaranty Corporation
Fortunately for retirees whose pensions may be at risk, the Pension Benefit Guaranty Corporation (PGBC) was created in 1974 to offer some protection.
The PBGC is a federally chartered corporation that manages struggling pension programs and provides insurance for at-risk pensions to ensure retirees receive their benefits. It currently manages nearly 5,000 pensions across the country and distributes benefits to 800,000 retirees every month.
How are pensions taxed?
Fortunately, most pensions are considered “qualified,” meaning any money contributed is tax-deferred. This means you don’t need to pay any taxes on these funds until you withdraw that money. How much tax you pay depends on a couple of things.
Keep in mind that these tax situations are for retirees who decided to receive their pension benefits through monthly annuity distributions.
- Fully taxed. If your employer contributed pre-tax dollars to your pension, then any money you withdraw from your account is fully taxable.
- Partially taxed. On the other hand, if after-tax dollars were contributed to your pension, then you only need to pay partial tax on this amount. This money is then taxed using the Simplified Method.
- Early distribution tax. If you remove any pension funds before the age of 59½, whatever money you withdraw will be subject to an additional 10% early distribution tax.
With all that said, your tax situation changes slightly if you take a lump sum payment. In this case, you will be responsible for the entire tax liability at the time benefits are disbursed.
The pros and cons of a pension plan
As you can imagine, pensions are highly desirable and are often attractive benefits that companies can offer potential employees in competitive hiring landscapes. Unlike market-driven retirement plans, pensions offer fewer long-term concerns.
Challenges of running a pension
While we covered some risks of pensions above, there are a few others to discuss in more detail. Pensions are far less common retirement plans today than they have been in the past. Many private companies used to use company pensions as primary retirement benefit packages, but nearly all use 401(k) packages instead.
Today, pensions are almost exclusively used for retirement benefits for public employees and union members.
Pensions require stability
Because a defined-benefit pension relies on the money being paid into the fund by current employees to disburse benefits to retiring employees, a company will need to maintain a steady rate of hiring. If more people are retiring than are being replaced with new pension contributors, the fund begins to reduce in size and may be in danger of disbursing reduced benefits or ceasing payouts entirely.
In short, this puts a company’s interest in streamlining production, optimizing personnel, and reducing costs through automation and robotic processes in direct conflict with their pension obligations. Pension funds become susceptible to changes in industry practices, consumer demand, supply chain fluctuations, and various other free market forces. This makes defined-benefit pension systems workable for types of employment where steady labor turnover in a large, predictably renewable labor pool is guaranteed, such as police forces and teachers’ unions.
Pensions may be leveraged for capital
Another risk with pensions is their liquidity. Pensions are essentially large reserves of potentially liquid assets that are available for struggling companies to borrow against or outright withdraw from in difficult economic times.
Since payouts almost never drain a pension fund entirely, it’s tempting to borrow against the current value under the assumption that the debt can be easily repaid without disrupting the disbursal of benefits. This practice is usually a somewhat dubious and even unscrupulous business practice, but nonetheless, the risk is there.
Pensions are at risk of fraud
Unfortunately, pensions have also been the target of corporate fraud or outright theft. A famous example of pension theft was British media tycoon Robert Maxwell’s skimming of nearly 400 million pounds off the Mirror Group pension fund throughout the 80s. This was only discovered after he had died in late November of 1991, and the damage to the retirement benefits of 32,000 employees was irreparable.
Pensions may be mismanaged
However, the most common reason for pension insolvency is non-criminal. A large pension fund requires tending by a responsible and skillful financial institution. It may fail if it is simply mismanaged by a company, or if the formula used for benefit disbursal is incorrect or doesn’t match future predictions of company health.
There have been many famous examples of pension funds that have collapsed in this way. For instance, steel companies like Bethlehem Steel, LTV Steel, National Steel, and Weirton Steel all suffered pension defaults as the steel industry dried up. Some employees in these systems lost pension promises worth well over $125,000 a year and found themselves with no retirement benefits and no income despite having paid into company pension funds for decades.
This left many employees and employers asking, “What is a pension good for if it can’t be reliably maintained?” As a result of these major failures, many private companies moved away from defined-benefit retirement packages to defined-contribution strategies such as the 401(k) that we are more familiar with today.
Key Takeaways
- Pensions are a type of retirement fund where the employer contributes funds rather than the employee. This differs from a 401(k), which requires employees to contribute money but does not require an employer to.
- There are two kinds of pension plans: defined-benefit plans and defined-contribution plans.
- You can opt to receive your pension benefits through a lump sum distribution, monthly annuity distributions, or a combination of the two.
- Depending on whether your employer contributes pre- or after-tax dollars will determine how your monthly distributions are taxed.
- Pensions can be great retirement funds but are also susceptible to mismanagement and fraud. Because of this, 401(k) retirement plans have gradually replaced traditional pension strategies.
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