What Is a Pension Plan & How Does It Work?

By Colin Dodds · May 11, 2023 · 6 minute read

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What Is a Pension Plan & How Does It Work?

A pension plan is a retirement plan offered by employers that guarantees income to workers after retirement. Pension plans are also known as defined-benefit plans because the monthly benefits the worker will receive during retirement is defined.

When defining those benefits, a pension may offer an exact dollar amount to be paid in retirement, such as $100 per month. But more often, the benefit involves calculating a number of factors, including how much the worker earned while working, how long they served the company, and how senior they were when they retired.

How to Get a Pension Plan

Unlike other different types of retirement plans, such as IRAs and Roth IRAs, an investor who wants to save for retirement can’t just go out and invest in a pension. Like 401(k)s, pensions need to be offered by an employer.

While pension plans were once a mainstay of how companies took care of their workers, they’ve become increasingly rare in recent decades. Only a small relative percentage of private sector employers offered some form of pension to their employees as of 2023.

The biggest reason why 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. But if an American works for the federal, state or local government, there’s a good chance that they may qualify for a pension. Among state and local government workers who participate in a retirement savings plan, a majority are in a pension plan.

How Pension Plans Differ from Other Retirement Plans

The key difference between pension plans and other retirement plans comes down to the difference between a “defined benefit” plan like a pension, and a “defined contribution” plan.

In a defined benefit plan, such as a pension, it’s clear how much workers will receive. In a defined contribution plan, it’s conversely clear to employees how much they put into it. Unlike a pension, a defined contribution plan doesn’t promise a given amount of benefits once the employee retires.

There are some plans, such as a 401(k) plan or 403(b) plans, in which an employer has the option to contribute. They are not, however, required to. In these plans, the employee and possibly the employer will invest in the employee’s tax-advantaged retirement account. At the time of the employee’s eventual retirement, the amount in the fund can depend heavily on how well the investments in the account performed.

There are still other retirement plans, like IRAs and Roth IRAs, which a worker can also fund. Like 401(k) plans, the ultimate payout often depends largely on the performance of the investments in the plan. But unlike 401(k)s, an employer isn’t involved or required to sponsor an IRA.

One big advantage that pensions have over defined contribution plans is that pensions are guaranteed by the federal government through the Pension Benefit Guaranty Corporation. 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)?

What to Do If You Have a Pension Plan

Workers with pension plans should talk to a representative in their human resources department and find out what the plan entitles them to. Every pension plan is unique. An employee may benefit from looking into the specifics, especially in terms of how much the plan might pay, whether it includes health and medical benefits, and what kind of benefits it will offer a spouse or family members if the worker dies first.

For someone just starting in their career, they 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 pro 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 worth investigating for workers with a pension. Employees who are considering a new role in an organization that offers a pension should also research such features.

A defined contribution plan can also motivate the worker to regularly calculate the amount they’ll have to live on after they retire, and when they can retire. That can open up questions about what they’ll do if they get sick or need at-home care. And by asking those questions, they can look into things like supplemental medical insurance or long-term care insurance, in order to better protect themselves down the road.

Cons of a Pension Plan

But the greatest strength of a pension plan — its reliability and its guarantee — can also be its biggest weakness from a planning standpoint. That’s because a pension can give would-be retirees a false sense of security.

A pension, with its well-insured promise of income, can lead people to ignore important questions and avoid strict budgeting for basic living expenses. That flat monthly income can also lead people to believe that their expenses will be the same each month.

And that can lead retirees to avoid planning for increased overall living expenses due to the effects of inflation or sudden, unexpected expenses that inevitably 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, potentially guaranteeing 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.

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