What Is a Pension Plan & How Does It Work?
While pension plans are less common today than they once were, many workers still receive a pension — a type of retirement plan that provides guaranteed income throughout retirement (or a lump sum at retirement).
Pension plans are known as defined-benefit plans because the benefits the worker will receive during retirement are predictable (i.e., defined). A 401(k) plan or IRA account, on the other hand, is called a defined-contribution plan — because workers typically contribute a defined amount each month.
Pensions are employer-provided benefits; an individual can’t set up a pension as they would an IRA account — a key aspect of what a pension is and how it works.
Key Points
• A pension is a defined-benefit plan that gives employees a regular paycheck throughout retirement, or in some cases a lump sum upon retirement (i.e. the payment is defined).
• Defined contribution plans, like 401(k)s, rely on worker savings but don’t provide a guaranteed payout like defined benefit plans.
• A pension is an employer-provided plan; workers cannot set up a pension plan.
• Pension plans are less common today; about 19% of U.S. private sector and government workers were eligible for a pension in 2024.
• While workers can choose their investments in a defined contribution plan like a 401(k) or 403(b), workers in pension plans cannot.
How to Get a Pension Plan
Unlike other types of retirement plans, such as IRAs, an investor who wants to save for retirement can’t simply fund a pension on their own. Like 401(k) plans, pension plans must be offered by an employer.
While pension plans were once a mainstay of how companies took care of their workers, they’ve become rare in recent decades. Only a small percentage of private sector and government employers — about 19% — offered some form of pension to their employees as of 2024.
The main reason many companies no longer offer pensions is that it’s cheaper for them to offer defined-contribution plans, such as 401(k) or 403(b) plans. That said, if an individual works for the federal, state, or local government, they may be offered a pension.
Among state and local government workers who participate in a retirement savings plan, a majority are in a pension plan.
Recommended: A 4-Step Guide to Planning Retirement
Pension Plans vs. Other Retirement Accounts
The key difference between pension plans and other retirement plans comes down to the difference between a “defined benefit” plan and a “defined contribution” plan.
• With a defined benefit plan, such as a pension, the amount workers will receive in retirement is predictable: e.g., $2,000 per month, which is valuable when you’re living in retirement.
• With a defined contribution plan, such as a 401(k) or similar, employees’ contributions, or savings, are defined: e.g., $500 per month. Unlike a pension, a defined contribution plan doesn’t guarantee a fixed benefit amount once the employee retires.
401(k) vs. Pension Plan
Although 401(k) plans and pension plans are both types of tax-deferred accounts that aim to provide workers with income in retirement, they differ in a few ways.
• Funding and contribution limits
While the employer provides the bulk of funding for a pension plan, 401(k) plans are primarily funded by the employee. In some cases, an employer has the option to contribute to the 401(k) through matching funds. (Employers are not, however, required to provide an employer match.)
Another key difference is the annual contribution limit for each type of account.
For tax year 2025, employee contributions to a 401(k) plan are capped at $23,500 per year ($31,000, if you’re 50 and older), with a total limit of $70,000, including employer contributions.
The maximum total annual contribution to a pension plan for 2025 is $280,000.
• Roth designation
There are other points of distinction between pension plans and 401(k) plans. For example, a 401(k) plan may offer a Roth feature (i.e., a Roth 401(k) account), which allows workers to contribute after-tax funds, and take tax-free withdrawals in retirement. Pensions generally do not offer a Roth option.
• Income and Taxes
As noted, the income from a pension plan is guaranteed, and thus a defined benefit.
But the income from a 401(k), 403(b), Roth or traditional IRA, or other defined contribution plan depends on the amount the employee has saved over time, and the investments they selected for their portfolio, and how those investments performed.
Also, because a pension provides a guaranteed payout (typically monthly), these plans do not come with required minimum distributions (RMDs), as 401(k) plans do.
The income from both a pension and a regular 401(k) is considered taxable income, however.
Pension Plan vs. IRAs
Individuals can also contribute to tax-advantaged IRAs and Roth IRA accounts. These are also quite different from pension plans. First, IRAs are Individual Retirement Arrangements, and they are a type of defined contribution plan that only an individual can set up (employers generally cannot offer IRAs, although small businesses may offer a SEP IRA or SIMPLE IRA to employees)
• Funding and contribution limits
The annual contribution limits for traditional and Roth IRAs for tax year 2025 is $7,000 per individual, with an extra $1,000 catch-up contribution for those 50 and older, for a total of $8,000.
Since standard traditional and Roth IRA plans are self-funded, there is no employer match. Small-business IRAs, like SEP and SIMPLE accounts, may offer an employer match.
• Roth accounts
The Roth designation refers to the use of after-tax money to fund a retirement account, such as with a Roth IRA. Roth IRA account holders invest after-tax funds, and qualified withdrawals are tax-free in retirement.
However, pension plans are tax-deferred accounts; the employee pays tax on their pension income in retirement. Typically, defined-benefit plans don’t offer a Roth option.
• Income
Like other defined contribution accounts, IRA investors can choose the investments in their portfolio. As a result, the ultimate payout from these plans depends on the amount saved and the performance, or returns of the investments in the plan.
Traditional IRAs are tax-deferred accounts, so withdrawals are subject to ordinary income tax. And traditional IRA holders must take RMDs, starting at age 73 (which is older than social security retirement age). Roth IRAs are not subject to RMD rules.
One advantage that pensions have over defined contribution plans is that pensions are guaranteed by the federal government through the Pension Benefit Guaranty Corporation (PBGC). It effectively guarantees the benefits of pension-plan participants. But the PBGC does not cover people with defined contribution plans.
Recommended: What Is a Money Purchase Pension Plan (MPPP)?
Managing Your Pension Plan
Workers with pension plans should talk to a representative in their human resources department and find out what the plan offers. Every pension plan is unique. An employee may benefit from looking into the specifics such as:
• The pension benefit amount
• Whether it includes health and medical benefits
• What kind of benefits the pension will offer a surviving spouse or family members.
Someone just starting in their career may also want to ask when their pension benefits vest. In many plans, the benefits vest immediately, while others vest in stages, over the course of as many as seven years, which could affect their plans to move on to a new job or company.
One way to get a better handle on what a pension may pay over time is to inquire about the unit benefit formula. Utilizing that formula is how an employer tallies up its eventual contribution to a pension plan based on years of service.
Most often, the formula will use a percentage of the worker’s average annual earnings, and multiply it by their years of service to determine how much the employee will receive. But an employee can use it themselves to see how much they might expect to receive after 20 or 30 years of service.
Pros of a Pension Plan
Perhaps the biggest advantage of a defined-benefit plan is the guarantee of predictable income from the day a worker retires until the day they die. That’s the core promise that the PBGC protects.
Many pension plans also include related medical and other benefits for the employee, as well as related benefits for surviving spouses. Those benefits vary widely from plan to plan and are important to investigate.
A defined-benefit plan enables workers to predict the amount they’ll have to live on after they retire, and when they can retire. This can help workers plan for other needs, such as supplemental medical insurance or long-term care insurance, in order to better protect themselves down the road.
Cons of a Pension Plan
The downside of knowing that a pension will provide guaranteed income is that it can give would-be retirees a false sense of security.
A pension, with its promise of steady income, can lead people to ignore important questions, and avoid budgeting for basic living expenses.
That flat monthly income might also lead people to believe that their expenses will be the same each month — which is rarely the case.
And that can lead retirees to avoid planning for increased overall living expenses due to the effects of inflation or sudden, unexpected expenses that may crop up.
There’s also the likelihood that their expenses later in life could be significantly higher, as they’re able to accomplish fewer daily necessities themselves.
That’s why, regardless of how thorough a pension plan is, it can pay to save for retirement in other ways, including through a 401(k), IRA or Roth IRA. Just because a worker has a pension, that doesn’t mean that it’s the only retirement plan that’s right for them. And employees will benefit from preparing for retirement early.
The Takeaway
Pension plans are a type of savings plan that are offered by employers, guaranteeing a certain amount of income to workers after they retire. Pension plans are defined-benefit plans, and differ in some key ways from IRAs or 401(k)s. Pensions have become less common in recent decades, and they have their pros and cons, like any other financial product or service.
Prepare for your retirement with an individual retirement account (IRA). It’s easy to get started when you open a traditional or Roth IRA with SoFi. Whether you prefer a hands-on self-directed IRA through SoFi Securities or an automated robo IRA with SoFi Wealth, you can build a portfolio to help support your long-term goals while gaining access to tax-advantaged savings strategies.
FAQ
What is a pension plan?
A pension plan is a type of defined-benefit retirement plan offered by employers. Pensions are known for providing a guaranteed amount of income to retired workers. But pensions today are uncommon, and have largely been replaced by defined contribution plans like IRAs and 401(k)s.
How do pension plans work?
Generally, an employer maintains a pension fund that will pay workers’ income benefits when they retire; in some cases, workers may also contribute to their pensions. At retirement, the employee receives a guaranteed amount of income, often monthly. Because pension benefits are paid regularly, these accounts don’t have RMDs. Pension income is taxed at ordinary income rates.
What are the different types of pension plans?
Pension plans vary, so it’s important to know what the rules and restrictions are. For example, a defined-benefit plan uses a basic formula to calculate the amount the employee will receive. A cash-balance plan bases a worker’s payout on the account balance, while still providing a guaranteed income. In addition, some pensions may include insurance or spousal benefits (or not). Be sure to know the terms.
How do pension plans compare to 401(k)s and IRAs?
While there are several differences between these accounts, the most important distinction is that pension plans are defined-benefit plans that provide guaranteed income throughout retirement (or a lump sum) for the employee. Defined-contribution plans, like 401(k)s and IRAs, do not provide guaranteed income; rather, the account holder takes withdrawals in retirement.
Another important point is that an individual can set up a defined contribution plan and select the investments in their portfolio, but they cannot join a pension unless they work for a company that offers one.
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOIN-Q125-081
Read more
