What Is a Pension Plan and How Does a Pension Work?

By Anastasia Hinojosa

Updated August 12, 2021 | Published March 30, 2020

Updated August 12, 2021

Published March 30, 2020

Anastasia Hinojosa is an experienced financial accountant with degrees from Texas A&M-Corpus Christi and Columbia University. She has worked in the healthcare field for over ten years.

A pension plan is one of the many benefits an employer can offer to an employee. The employer pays into the fund and the employee receives a specific amount of money upon retirement. In this article, we discuss what a pension is, outline how they work and answer several common questions about them.

What is a pension?

A pension is a type of retirement plan that provides monthly income after you retire from your position. The employer is required to contribute to a pool of funds invested on the employee’s benefit. As an employee, you may contribute part of your wages to the plan, too.

Not all businesses offer these plans. They're most common in government organizations and large corporate entities.

How does a pension plan work?

Pension plans require your employer to contribute money to your plan as you work. Once you retire, you earn the accrued pension money divided into monthly checks. In most cases, a formula determines the amount you receive. Some of the formula variables include your age, compensation and years of service to the company.

Pension plans follow specific rules set by the U.S. Department of Labor. These rules control how much money companies set aside each year into investment funds for employee pensions. Pension benefits are also subject to a vesting schedule. They may follow a cliff vesting schedule or a graded vesting schedule.

Cliff vesting schedule

A cliff vesting schedule means that you are eligible to receive 100% of earned benefit at a certain year. For example, with a five-year cliff, if you leave before your fifth year, you receive nothing. If you leave after year five, you will receive 100% of the money that you are entitled to based on the pension formula.

Graded vesting schedule

A graded vesting schedule means that you are entitled to a certain percentage of the earned benefit the longer you work at the company. For a seven-year graded vesting schedule, you may get nothing in the first and second years, 20% the third year, 40% the fourth year, 60% the fifth year, 80% the sixth year and 100% the seventh year. The actual amount of your benefit will depend first on the pension formula and second on the vesting schedule.

If you leave your job before retirement, you may be able to collect a lump sum for the pension you have earned or you may have to wait until retirement to access the funds. If you are required to wait until retirement, then you must contact the company when you retire to set up your annuity. If you take the money as a lump sum, you may pay a penalty for early distribution.

If you're unsure about your company's vesting schedule, speak with a human resources representative and ask about your company's minimum requirement for a pension.

Types of pension plans

There are two main types of pension: defined-benefit and defined-contribution. A less common type is the “pay-as-you-go” pension.

1. Defined-benefit plan

In a defined-benefit plan, the amount of money received upon your retirement is specified upfront. It is not impacted by how well the investment pool performs. The employer is liable for the payments and the amount is usually based on years of service and salary. The amount of money you receive if you leave before your retirement is determined by a vesting schedule.

The potential drawback is you do not have control over the amount accrued. Pension benefits give you the same amount per check for the rest of your life.

2. Defined-contribution plan

In a defined-contribution plan, the employer contributes a specific amount which is usually matched by in some degree by the employee. The final benefit for the employee depends entirely on the plan’s investment performance. This is becoming a more popular plan, especially with private companies, since there’s no liability for fund generation.

The most common defined-contribution plan is the 401(k) for 403(b) for nonprofits. The amount your 401(k) has depends upon how much you contributed while employed. It's also affected by market conditions, which can be volatile.

If you leave a job before retirement, you can take your 401(k) with you by keeping the account open or rolling it over into a new account.

Related: 4 Things You Can Do With 401(k) After Leaving Your Job

3. Pay-as-you-go plan

A pay-as-you-go plan is less common and set up by the employer but wholly funded by the employee. You can select salary deductions or lump sum contributions to fund the plan. There is no company match. Social Security is an example of a pay-as-you-go program.

Related: Q&A: What’s the Difference Between a Pension and 401(k)?

Planning for retirement with a pension plan

For many new retirees, Social Security, employer pensions and personal savings all factor into their monthly income. Here’s how to help prepare:

  • Determine how your pension fits with the rest of your retirement and other income.

  • Study the plan documentation and find out how much you're eligible to receive.

  • Identify the criteria you need to meet for maximum payouts.

  • Research age requirements and required minimum distributions on the IRS website. These guidelines can change as new laws are passed, so you should research these requirements whenever you are considering taking a distribution.

  • Find a retirement calculator online and input your estimated pension benefit with your Social Security benefit and other income sources. This will help you determine if your retirement goals are obtainable in your current financial state. If your number is less than you hoped for, use the calculator to help set benchmark savings goals for yourself.

FAQs about pension plans and payments

Here are several common questions and answers about pensions:

Can my employer terminate my pension?

If a company offers a pension, they have a right to terminate it. When termination occurs, your accrued benefits are frozen. You receive all earnings up that point but there is no more accumulation for additional pension income.

What is a public pension?

A public pension is a type of pension offered to employees in the United States public sector. They're available at the federal, state and local levels of government and most government employees meet eligibility requirements.

Do the recipients of public pension also get Social Security?

According to the National Public Pension Coalition, there are several states that don't contribute to Social Security. Employees in these states are ineligible for Social Security benefits during retirement. In states that do contribute, employees earn both their Social Security and pension benefits.

Are there tax consequences?

You do not pay taxes on a pension plan until you begin receiving payments. These distributions are treated as ordinary income on your tax return, which means that it is taxed as if it were regular income you earned as a salary or wage. If you withdraw the money early, you may face an early distribution penalty. If you wait until retirement to withdraw the money, you may face a minimum distribution penalty if you take out less than the required minimum distribution.

Is a pension plan right for my situation?

If your employer provides pension plans, research their offerings thoroughly before enrolling. Plan options differ widely and many are more practical for specific careers or career choices. Working at a company long enough to reach its minimum requirements can lead to valuable pension benefits. If you're comfortable staying with them long-term, their pension plans may be your best option. They provide guaranteed income in retirement compared to other retirement plans that come without guarantees.

Understanding your pension plan and the associated benefits prepares you for evaluating the rest of your retirement income. This information is beneficial when determining your savings strategy for retirement. If you need more information about your company’s retirement plans, contact your human resources representative.

How should I take my payments?

A pension payment may be taken in a monthly payout, called an “annuity.” It provides a steady, known income each month. If you take all the money at one time, it’s called a “lump sum” payment. It becomes your responsibility on how much of the amount you spend or invest.

What are some alternatives to pensions?

Other options include 401(k)s, defined contribution plans, individual retirement accounts (IRA), nonqualified deferred contribution plans, guaranteed income annuities and more. Understanding the tax consequences of each plan is important for choosing which plan will work best for you. Some plans are tax-deferred, which means that contributions are tax-deductible when you make them, but you will pay taxes later on the distributions. Other plans have contributions that are taxed, which means that later distributions are not taxed.

Related: Understanding Early Retirement Packages

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