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INVESTING RETIREMENT PLANNING

Part of RETIREMENT PLANNING 101

What Is a Pension?
Pensions Explained in Less Than 4 Minutes
BY D A N A A N S P A C H Updated January 25, 2022
REVIEWED BY M I C H A E L J B O Y L E Advertisement

Table of Contents
DeOnition and Example
of a Pension

How a Pension Works

Alternatives to
Pensions

The Balance / Maritsa Patrinos

A pension is a retirement plan that provides a monthly income. The employer bears all
of the risk and responsibility for funding the plan.

Learn more about pensions, how they work, and what determines pension income for
eligible retirees.

Definition and Example of 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 oJer pensions, but government organizations usually do.

An employee who receives a pension typically gets a set amount of money every
mont, for the rest of their life.

Warning: Not every pension adjusts for in\ation. If you're entitled to a

 pension, don't assume that it will include a cost-of-living adjustment. [1]

How a Pension Works

A formula determines how much pension income you will receive once you are
retired.
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The formula that a pension plan uses is typically based on the following factors:

• Your years of service with the company

• Your age
• Your compensation [2]

For example, a pension plan might oJer a monthly beneOt of 50% of your pay (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, you might be able to work longer and retire at age 65 with 30
years of service. The pension could provide an income of 85% of your pay. More years
usually mean more money.

Pension plans must follow speciOc rules set by the U.S. Department of Labor. These
rules state how much a company must place into a pension fund each year to provide
its workers with an income when they retire. [3]
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Your pension may be subject to a vesting schedule that dictates how much you
would get based on how long you've been with the company. [4] For example, you
may have to work for the employer a minimum of Ove years before you would be able
to receive a pension. Your company decides in advance what this schedule will be.

Tip: If you are in a pension plan that allows employee contributions, yours
are vested immediately.

Taxes on Pensions
Most pension beneOts can be taxed. When you begin taking pension income, you'll
need to decide whether you should have taxes withheld from your pension payment.
If you contributed after-tax money to the pension, that portion of your pension might
be tax-free. [5] Some military and government pensions are exempt from taxes if the
member was injured on duty. [6]

Pension Terminations
If your employer oJers a pension, it can decide to end it. In that situation, your plan
would be frozen. That means you would get the amount you had earned up to that
point. However, you would not be able to build any additional pension income. [3]

Sometimes, pension plans are managed poorly and aren't able to make payments.
The Pension BeneOt Guaranty Corporation (PBGC) will step in to pay your vested
income, up to the amount allowed by law. [4] The amount you would receive varies
according to your age when you retire and whether the plan oJers beneOts to your
spouse if something were to happen to you. [7]

Alternatives to Pensions
The advantage of a pension plan is it provides secure income. Many companies have
stopped oJering pension plans. [8] That means the burden of saving to retire falls on
you. You must Ogure out how to save enough to create your own pension-like
income.

Most pension plans have been replaced by 401(k) plans, which oJer a variety of
investment choices. Rules allow employers to oJer a qualiOed longevity annuity
contract (QLAC) within a 401(k) plan. QLACs can provide secure income to you when
you retire. [9] If your company oJers this option, you can invest in it to create an
income you can count on.

Individual retirement arrangements (IRAs) are another alternative to a pension. They

are savings accounts that have tax advantages. You can choose how to invest the
funds in your IRA, and some employers match your contributions. 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. [10]

Key Takeaways

• A pension is a retirement plan that provides a monthly income in

retirement.

• Unlike a 401(k), the employer bears all of the risk and responsibility for
funding the plan.

• A pension is typically based on your years of service, compensation, and

age at retirement.

• 401(k)s, qualiOed longevity annuity contracts, and IRAs can serve as

alternatives to pensions.

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