How Does a Pension Plan Work?

By Anjannette ConnerLast Updated April 22, 2019
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Retirement is a glorious time of life most people look forward to with excitement, especially if they’ve planned well for those future golden years by tucking away a nice retirement fund to help them live comfortably. For most employees in the private sector, that means setting up a 401(k) or some other type of retirement account they can contribute part of their paycheck to each month. For those in the public sector, pension plans that consist exclusively of employer contributions are much more common. 

Historically, pension plans first became popular in World War II, and they have remained key benefit components for government employees and unionized workers since that time, although some private companies also have pension plans. Businesses who use them agree to pay their employees set benefit amounts throughout their retirement years. The exact amount you can expect to receive increases each year that you work for the company. To make the details even more confusing, some plans have evolved to also include employee participation. Here’s a quick look at how a pension plan works.

Basic Elements of a Pension Plan 

The specific details for pension plans vary from organization to organization, especially for private sector companies who offer pension plans, but the general ideas are usually similar. The employer makes investments in a pension fund and attempts to grow that fund each year to ensure funds are always available to make monthly pension payments to employees who have already retired. Both company and employee contributions to pension plans are tax exempt until the funds are withdrawn.

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The basic calculation for determining the amount of an annual pension usually includes adding a set percent for each year the employee worked for the company and multiplying the total percentage by the average salary of the employee for the final five years of service. Private sector pension plans often set the percentage at 1% per year, while government-based public pensions usually pay around 2% per year of service. That means an employee who worked for a company for 20 years at an average salary of $50,000 would have an annual pension of $10,000 at 1% per year or $20,000 at 2% per year. 

Types of Pension Plans

Pension plans come in two different forms: defined benefit plans and defined contribution plans. A defined benefit plan follows the traditional format that positions the pension purely as a benefit to the employee with the total cost paid by the employer. Regardless of how the company’s pension fund investment performs in the future, the employer commits to paying each employee a fixed amount throughout their retirement. If the fund comes up short, the employer is obligated to pay the full amount of the pension.  

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A defined contribution plan follows the model of a typical 401(k) investment plan. Employees make contributions themselves, and their employers also make contributions, usually based on matching some portion of the employee’s investment. The future benefits paid to employees are dependent on the performance of the plan.

How Do Pension Plans and 401(k) Plans Differ?

A 401(k) is a type of defined contribution plan. It relies heavily on the contributions of individuals, although employers may contribute funds as well. Because 401(k) accounts are tax exempt until money is withdrawn, several legal rules govern withdrawals, but the employee has some say in overall account management. 

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Pension plans don’t cost employees a dime and provide free money for the future as a perk of years of service to the company, but participants can’t make any investment decisions and don’t have access to their accounts until retirement. Fund managers create a portfolio for their state pension entitlement under a defined contribution plan, diversify the funds into investments and then disburse them after retirement.

Choose a Lump Sum Payment or a Monthly Annuity

Pension plans usually offer recipients two ways to receive their money in retirement: a one-time lump sum payment or a monthly payment called a monthly annuity. Employees also have to decide if they want a single-life pension that only pays funds to them until their death or a joint survivor pension that continues to pay the surviving spouse after their death. The downside to the latter is the total annual pension amount paid is lower — usually by about 10% — and the spouse could pass away before the retired employee.

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Choosing a payment method depends on your individual needs. Some people prefer to withdraw the money in a lump sum and place it in a private retirement account they control, while others prefer the convenience of receiving reliable monthly payments. The lump-sum option is also beneficial when employees want to pay off all their debt and move into retirement with no monthly expenses beyond simple living expenses. 

Understand the Vesting Schedule

Before employers hand over large amounts of money to former employees for retirement, they generally require the employees to meet certain qualifying criteria. The main way they restrict pension participation is through a vesting schedule. Employees may become eligible for employer pension contributions within a year of employment, but those funds must be vested before employees can access them in the future. 

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In rare cases, vesting occurs immediately after the contribution, and the funds are fully available as soon as an employee retires, regardless of how long they worked for the company. However, in most cases, the vesting process usually takes several years of employment for an employee to reach a fully vested status that entitles them to the full amount of the funds when they retire. The purpose of this approach is to ensure only employees who devote a substantial amount of time to the company actually receive a full pension.

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