What Is a Pension?

A pension is monthly retirement income paid for by a former employer. Pensions remain common for government employees but have largely been replaced by defined contribution plans — such as 401(k)s — in the private sector.

Understanding Pensions Plans

A pension plan is a retirement plan that requires an employer to make contributions to investments set aside for a worker’s retirement.

Employees can typically choose to receive either a lump sum when they retire — or leave the company — or receive regular payments for life through an annuity.

A formula usually determines the size of your pension income in retirement.

Several factors influence your pension payment, including:
  • How many years you worked at the company.
  • Your age.
  • Your salary at the company.

Usually, employees must work at a company for a certain time before the benefits they earned belong to them.

Pension plans are regulated by the Department of Labor. Rules specify how much your employer must set aside each year into an investment fund to provide you with a future defined pension income.

Most pension benefits are taxable. However, some military and government pensions paid out because of a disability are not taxed.

Pensions became popular following World War II but are increasingly rare in the private sector. They remain common for government employees, including teachers and military service members.

Did You Know?
In 2019, only 16 percent of private sector workers had access to a defined benefit pension plan, while about 86 percent of state and local government employees had access to these plans.

The Two Types of Pensions

Two kinds of retirement plans are covered by the Employee Retirement Income Security Act: Defined benefit and defined contribution.

When people talk about pension plans, they are often referring to defined benefit plans, which offer a set payout funded and controlled entirely by the employer.

A defined benefit plan promises a specific amount of money in retirement — regardless of the performance of underlying investments.

These plans often use a formula or percentage to calculate how much money you receive. Your working salary and years of service factor into this formula.

For example, an employer may calculate your defined benefit as 70 percent of your average salary for the last five years of employment with the company.

Most traditional defined benefit plans are protected — up to a certain limit — by the Pension Benefit Guaranty Corporation.

In contrast, a defined contribution plan does not guarantee a specific amount of fixed income at retirement.

Instead, the worker, employer or both contribute to an individual employee’s account, sometimes at a set rate.

Defined contribution retirement plans allow workers to invest pre-tax funds into the market, where money often grows tax-deferred until retirement

Popular examples of defined contribution retirement accounts include 401(k)s, 403(b)s, employee stock ownership and profit-sharing plans.

Pension Risks

A perk pensions offer is that employers bare responsibility for managing plans and making sure funds are properly invested.

However, this lack of control may also put employees at risk because they are unable to ensure that pension funds are adequately financed.

Unlike with a 401(k) plan or Individual Retirement Account (IRA), you don’t have input on how your company invests money for your future.

Poorly invested pension funds could result in a reduction of your benefit without warning.

By law, employers who offer pensions must provide participants with a funding notice each year.

Because these retirement plans are very expensive to maintain, employers may cut or freeze pension benefits during times of economic hardship or after declaring bankruptcy.

In these cases, the Pension Benefit Guarantee Corporation offers some protection.

This federal agency protects benefits in private-sector defined benefit plans. However, the PBGC may not necessarily pay the full benefit originally promised to you by your employer.

Alternatives

In the private sector, 401(k) plans have largely replaced the traditional defined benefit pension. This shifts the responsibility of retirement planning from the company to you.

Some employers will offer to match 401(k) contributions, up to a certain percentage. You can contribute more than your workplace match in order to save additional money for retirement.

An IRA is another alternative to a pension. They act as savings accounts with tax advantages.

With a traditional or Roth IRA, you are completely in control of how funds are invested. These retirement accounts can be opened at a bank, credit union or online brokerage company.

Finally, annuities are financial products that can be structured to provide lifetime income, similar to a pension.

You purchase an annuity contract with a sum of money from an insurance company. The insurer invests your money in mutual funds, stocks or bonds. When you retire, you can begin receiving regular payments from your annuity.

Annuities offer more flexibility than pensions because you decide how much money to put in and the details of the contract you sign. However, annuities are often complex and include annual fees. Make sure to understand all the costs, benefits and disadvantages of an annuity before signing a contract.

Last Modified: October 9, 2020

7 Cited Research Articles

  1. Bomey, N. (2019, December 10). ‘It's really over': Corporate pensions head for extinction as nature of retirement plans changes. Retrieved from https://www.usatoday.com/story/money/2019/12/10/corporate-pensions-defined-benefit-mercer-report/2618501001/
  2. Sabelhaus, J. and Henriques Volz. A. (2019, November 7). Are Disappearing Employer Pensions Contributing to Rising Wealth Inequality? Retrieved from https://www.federalreserve.gov/econres/notes/feds-notes/are-disappearing-employer-pensions-contributing-to-rising-wealth-inequality-20190201.htm
  3. Pension Benefit Guaranty Corporation. (2013, April 17). What is a Pension? Retrieved from https://www.pbgc.gov/about/who-we-are/retirement-matters/post/2013/04/17/What-is-a-Pension
  4. Morrissey, M. (2013, January 11). Private-sector pension coverage fell by half over two decades. Retrieved from https://www.epi.org/blog/private-sector-pension-coverage-decline/
  5. Governmental Accounting and Standards Board. (n.d.). What Are The Different Types of Pension Plans? Retrieved from https://www.gasb.org/jsp/GASB/Page/GASBSectionPage&cid=1176163527901
  6. Pension Benefit Guaranty Corporation. (n.d.). What is the Pension Benefit Guaranty Corporation (PBGC)? Retrieved from https://www.pbgc.gov/about/faq/pg/general-faqs-about-pbgc
  7. U.S. Department of Labor. (n.d.). Types of Retirement Plans. Retrieved from https://www.dol.gov/general/topic/retirement/typesofplans#:~:text=Examples%20of%20defined%20contribution%20plans,relatively%20uncomplicated%20retirement%20savings%20vehicle