What is a Pension?

From 401(k)s to IRAs to pensions, retirement plans and programs come in a variety of forms. For this article, we’ll focus on pensions.

A pension is an employee benefit for which the employer makes regular contributions to an account. Once the employee retires, that account then makes regular distributions to the retired employee.

The U.S. Department of Labor defines a pension as “an employee benefit plan established or maintained by an employer or by an employee organization (such as a union), or both, that provides retirement income or defers income until termination of covered employment or beyond.”

Pensions were once the norm for U.S. workers, but have faded in popularity in the private sector in recent years. In 1980, 38% of private wage and salaried workers had a defined pension compared to just 20% in 2008. Today, pensions exist largely among government employees.

How Does a Pension Work?

While an employee is working, the employer will gradually set aside funds into an account. Some pension plans also allow the employee to make contributions to the account as well.

Once the employee retires, money from the account is distributed to the retired employee in monthly installments. Some pension plans provide the option of receiving one lump sum payment of a predetermined amount instead of monthly payments.

Some pensions make payments for the rest of your life. And some will even make payments to your surviving spouse after you pass away. Other pension plans will make payments only for a select number of years during retirement. 

The amount that is paid out in a pension plan usually depends on the salary of the worker and the number of years they worked for the company. For example, a plan might pay 1% of the worker’s average salary for each year they were employed by the company.

If the employee worked for the company for 20 years with an average salary of $50,000 per year, they would receive $10,000 per year as a pension, or about $833 per month.

A pension plan may adjust distributions based on inflation, interest or cost of living.

How Many Years Do You Have to Work to Get a Pension?

The number of years of service required to collect a pension depends on the company or government providing the pension and can vary greatly. 

For instance, teachers have a median of 24 years of service before they are eligible for a pension. But in certain states and districts the eligibility can be as little as five years or less. 

Police officers and firefighters have a median of 18 years of service for pension eligibility, but that number can range from under five years to more than 25 years depending on department, location and position. 

What Is a Pension Plan vs. Pension Funds?

A pension plan refers to the plan itself. That is, the eligibility requirements, distribution amount and schedule and so forth. 

“Pension funds” refers to the amount of money in the pension account that will be available for distribution. 

What Is a Defined Benefit Pension Plan Vs. Defined Contribution? 

A defined benefit plan guarantees a monthly (or lump sum) payment to a worker in retirement using a defined distribution based on salary and years of employment. Employees may make contributions to these plans in some cases, but they are primarily funded by the employer. 

A defined contribution plan uses stocks and other investments to generate retirement income for the employee. An employer may contribute money to the plan, but it is funded primarily by the employee. 

A traditional pension is considered a defined benefit plan while a 401(k) is a defined contribution plan. 

What Is A 401(K) Vs. A Pension? 

A pension has a lot in common with a traditional 401(k). Both are employer-sponsored retirement plans, but the fundamental difference is that a pension is a defined benefit plan while a 401(k) is a defined contribution plan. 

A pension provides a more concrete and pre-determined amount of money that will be available to the employee upon retirement. The money in a pension fund is invested for growth, but the distribution to the retired worker is predetermined and not based on the performance of the investments. 

Meanwhile, the value of a 401(k) is more performance based and will be affected by the stock market and other outside factors. The amount distributed to the retired employee will depend largely on how well the portfolio performs over time. 

With a pension, the employer bears the financial risk and responsibility of making income available to its employees in retirement and may need to be insured by a government agency like the Pension Benefit Guaranty Corporation.

With a 401(k), the employee assumes more responsibility and maintains some control over how the account grows and performs and may choose how much or how little to contribute and how they want the money to be invested.  

What Is A Non-Qualified Pension Plan?

A non-qualified pension plan is one that operates outside the regulations of the Employee Retirement Income Security Act (ERISA). These plans are typically reserved for executives and other higher-ranking employees and are designed to meet specific retirement goals. 

Non-qualified plans often use bonus money and life insurance plans on a deferred basis to generate income for the pension account. In other words, a portion of their income is deferred until retirement at which time it is paid as a bonus.

Deferring some salary in this manner allows the income to grow tax-deferred until it is distributed and can help keep the employee in a lower tax bracket during their working years. —

Non-qualified plans are typically used as supplemental retirement plans on top of a traditional 401(k) or other plan as qualified plans generally have limits on how much can be contributed.