How Do Pensions Work?

how does a pension work

Are you counting on a pension when you retire? Are you familiar with how it works? In this article, we will give a quick overview of how a pension plan works, different types of pension plans, and how payments from a pension plan to retirees work.

Once you have a better understanding of how your pension works, you will be in a better position to make well-informed choices about your overall retirement. That can include whether other sources of retirement income will help you reach your goals. Read on for a deeper dive into the basics of a pension plan and how it works.

What Is a Pension Plan?

A pension plan is a retirement plan that is generally provided by an employer. The pension plan makes monthly payments to retirees over time. Those payments are usually based on someone’s salary and how many years they worked at that employer.

Classic pension plans, rapidly disappearing over the last few decades, offer a monthly payment to retired employees. The vast majority of the lucky few who still have a plan are federal employees and other public employees. Some corporations still offer pensions to new hires, although that number is shrinking, according to research by Towers Watson.

What Are the Different Types of Pension Plans?

There are two primary types of pension plans: defined benefit plans and defined contribution plans. Most of what we think of as traditional pensions are defined benefit plans. A 401(k), on the other hand, is a defined contribution plan.

Most of the risk is on the employer in the defined benefit plan. On the other hand, the employee shoulders most of the investment risk in a defined contribution plan.

A Brief Side Trip to ERISA

In 1974, after some irregularities arose with the Teamsters Union Pension Fund, Congress passed the Employee Retirement Income Security Act (ERISA) to protect employee retirement assets.

The law puts strict standards on employee pensions, making those who run them fiduciaries by law. ERISA also requires that employees receive certain information periodically about their plans. It also generally prohibits loans for building hotels in Las Vegas.

In sum, ERISA is the most critical factor in the structure of modern pension and employee benefit plans of all types.

How Does a Pension Pay You and Others in Retirement?

There are stages in how a pension plan works. These stages affect what and how someone will get paid.

Pension Plans and Vesting

Vesting is essentially the process by which an employee eventually “owns” some share of the pension funds and will be paid on those shares.

First, in any plan in which the employee makes contributions (defined-contribution plan), those contributions vest immediately and totally. Should the employee leave, they can take 100 percent of those funds with them.

Employer contributions vest differently. This happens usually in a schedule outlined in the pension plan’s documents. These contributions may vest immediately, though this is rare, or over a schedule of up to seven years. Employees who leave before all assets are entirely vested will leave some portion of the employer contribution behind if they leave before retirement.

When and How Can You Receive Pension Payments?

Once an employee reaches a combination of years and age that is necessary to retire under a given plan, they may choose to do so.

At their retirement, they can take the stream of income established by the pension plan (usually monthly payments). Alternatively, they can take a lump sum withdrawal, which is often rolled over into another tax-qualified retirement account such as an IRA.

Pensions and Taxes

There are several tax issues relating to pension plan income. For example, money put into a defined-benefit or defined-contribution plan is usually made up of pre-tax dollars.

When that is the case, then the federal government will apply taxes to your income from the pension over the years. Funds in a plan are generally tax-deferred, not tax-free.

Some states also tax pension income. Fourteen states don’t tax pension income at all. Of the remaining states, 27 tax only a portion of your pension income. Current law makes all retirement income exempt from state income taxes beginning in 2023.

Pension Payment Structures

When you do start to receive payments, or when you set up what your future payments will be, it’s not simply a matter of saying, “start payments at 65.”

First, you can get annuity-type periodic payments or a lump sum. If you choose the first option, there are different options available. Let’s go over how these periodic payment options from a pension work below.

Single-Life Plan

This structure will make the highest payments but pays nothing after the employee dies. There are no benefits for the surviving spouse

Single-Life with Certain Term

This plan makes payments for a specified number of years, so long as the employee is alive. The beneficiaries will receive the remaining payments if the employee dies before the term ends.

Joint-and-Survivor Plan – 50 Percent

This plan provides payments of a given amount so long as someone lives. The surviving spouse receives 50 percent of the original payment amount when the employee dies. It’s a lower payment, but it does continue for the survivor.

Joint-and-Survivor – 100 Percent

Under this variation, the payments that continue after the employee’s death are the same amount as when they were alive. This is the excellent security available for the surviving spouse.

What Type of Pension Plan is Right for You?

Your pension plan choices will generally depend on your employer. Some state public employers have options for a defined benefit or defined contribution plan, such as the State of Florida.

At other employers, you might not have an option on what type of pension plan to use. In that case, your employer will offer a plan, and you can choose to participate in it or not.

The worker is usually better served by the increasingly rare defined benefit plan, while the employer will prefer the defined contribution plan.

Should you want a guaranteed income stream in retirement, a defined benefit pension plan may be a better fit for you. If you are okay with more investment risk in exchange for your money to have growth potential, then a defined contribution plan may be the ticket.

When Can You Access Your Pension Money?

In most cases, your pension plan will set when and how you may retire and receive payments. However, the Internal Revenue Service and ERISA also impact your payments.

Most pensions allow you to retire somewhere around 60 or 65, with some as early as 55. In many cases, you will find that pension plans will let workers start receiving payments at age 62. Tax qualified plans, however, generally penalize withdrawals or distributions, except for defined emergencies, before age 59.5.

How Are Pensions Taxed?

In most cases, you will owe federal income tax on your pension payments. Those payments are generally taxed at your federal marginal rate.

If you take a lump sum, you must pay taxes for the total amount. That is, unless you have rolled it into another tax-qualified retirement account.

Social Security benefits aren’t taxed unless you have other income beyond specified limits. In that case, as much as 85 percent of your benefits are taxable. Also, approximately $6,000 per person of private pension income is exempt from income tax.

What Happens to Your Pension When You Die?

The fate of your pension at your death depends primarily on the payment structure you set up. If you didn’t arrange for payments after your death, your pension plan simply ends without payment to any beneficiaries.

Can You Lose Your Pension?

Unfortunately, yes, there are circumstances under which you can lose your pension.

The first and most common problem is an underfunded pension plan. Essentially, it’s easy for today’s employers to make pension promises for the future but not pay for them today.

The Department of Labor tracks underfunded plans (less than 65 percent of the assets needed to make committed payments). The Pension Benefit Guarantee Corporation (PBGC) assists plans in danger of insolvency.

If your employer enters bankruptcy, its pension obligations may be discharged. In most cases, the PBGC will step in to cover some portion of the retirement assets.

Finally, church pension plans don’t have to pay into the PBGC fund. Therefore, these plans generally can’t rely on PBGC coverage if the employer fails. This leaves these employees at high risk.

Can You Cash Out Your Pension?

Yes, but generally this is a bad idea. Many pension plans allow for a lump sum retirement distribution or a lump sum distribution when you change employers.

In either case, if you don’t roll the assets into a tax-advantaged retirement account within 60 days of the withdrawal, you will owe taxes at your marginal rate on the entire amount.

Most commonly, those who take a lump sum cash-out will roll the assets into an IRA, or other tax-qualified vehicle like an annuity, to keep from paying taxes on the entire lump sum.

What Are the Differences Between a Pension and an Annuity?

A pension is a retirement plan created and run by an employer for employees. An annuity is an insurance contract that pays a guaranteed lifetime income stream to someone. The contractual stream of income can be used by somebody for himself or herself, or for another designated person.

It’s possible to take your lump sum retirement distribution and purchase a tax-qualified annuity with those funds. Because of the wide variety of features, benefits, and add-ons available in annuities today, starting an annuity may well allow you to tailor a retirement income plan more closely to your needs.

How Safe Is Your Pension?

As noted above, some pension plans seem to be at risk. Even government pensions can be seriously underfunded, making future payments risky.

If you think your plan is in danger, make sure to stay in contact and keep all your records so that you have them in the event you have to claim benefits in the future.

You can get help from private organizations, the Pension Rights Center, and the federal Employee Benefits Security Administration (EBSA). The latter even permits you to file a complaint about your pension.

Can You Take Your Pension If You Leave Your Job?

As a general rule, defined contribution plans can go with you. On the other hand, defined benefit plans will stay at your old employer and be there (with luck) for payment when you retire.

If your traditional pension is a cash-balance plan, you can move the money into another tax-qualified vehicle when you leave.

Do You Need Retirement Income From Other Sources Than a Pension?

Yes, you shouldn’t rely on any one source of retirement income for your retirement security. Social Security will, of course, factor into your retirement planning. But its future ability to pay full benefit payouts to all beneficiaries is unclear due to political pressures as well as partisan gridlock.

Pension plans, of whatever type, are also an open question. The defined benefit plan is disappearing and, where it does exist, is often at risk of failing. As we have seen recently, defined contribution plans are susceptible to market fluctuations and can suffer catastrophic losses.

IRAs, whether traditional or Roth, can add another leg to the traditional retirement stool. By starting to save early and taking advantage of compounding, these can end up representing significant assets.

Finally, there is the annuity. Annuities allow you to purchase a stream of income that can be finely tailored to your precise needs. They can, for example, be used to cover the gap between early retirement and Social Security. Or they can cover a spouse after your death. They can even be designed to cover long-term medical care or catastrophic illness.

An annuity is yours. So long as you have done your due diligence in purchasing an annuity, you should have a secure place to hold those assets and pay into your retirement income in precisely the fashion you need and want.

An annuity should definitely be part of your retirement income considerations.

Some Parting Thoughts on Pensions and Retirement

How, then, does a pension work? Quite simply, it’s a retirement savings plan that will pay you regular payments for life in retirement. A pension is one of the few things that can pay you truly guaranteed income, apart from Security and annuities.

However, a pension and its ability to make good on promised payments depends on the employer standing behind it. If the employer goes belly-up or wishes to unload some of its financial obligations, a pension plan is often on the chopping block.

The good news is that there are pension-like alternatives with annuities, and what’s more, annuities are customizable to your unique financial picture as well as income needs. Ask your financial professional for more information on pensions, how they work, and how other income sources such as annuities can help you in retirement.

What if you are looking for a financial professional to help you through these what-ifs? Many independent and experienced financial professionals are available at SafeMoney.com to assist you.

Get started by using our “Find a Financial Professional” section to connect with someone directly. You can request an initial appointment to discuss your situation and explore a potential working relationship. Should you need a personal referral, call us at 877.476.9723.

Next Steps to Consider

  • Start a Conversation About Your Retirement What-Ifs

    retirement planning services next steps

    Start a Conversation About Your Retirement What-Ifs

    Already working with someone or thinking about getting help? Ask us about what is on your mind. Learn More

  • What Independent Guidance
    Does for You

    independent vs captive advice

    What Independent Guidance
    Does for You

    See how the crucial differences between independent and captive financial professionals add up. Learn More

  • Stories from Others
    Just Like You

    safe money working with us

    Stories from Others
    Just Like You

    Hear from others who had financial challenges, were looking for answers, and how we helped them find solutions. Learn More

Proud Member