A pension is a retirement plan where an employer (and often the employee) contributes to a fund that pays a regular income in retirement, usually based on salary and years of service.
Types
- Defined benefit pension: pays a set income in retirement based on salary and years of service (for example, 1.5 percent x years x final salary).
- Defined contribution (401(k)): based on investments.
How it works
Employers (and often employees) contribute to a fund managed by professionals. At retirement, you receive monthly payments, usually for life.
Vesting
You must work a minimum period (often 5 years) to keep benefits.
Insurance
Private pensions are insured by the Pension Benefit Guaranty Corporation (PBGC).
Trends
Private-sector defined benefit pensions have fallen since the 1980s. Public sector workers still often have them.
Taxes
Pension income is taxed as ordinary income.
Options
Lump sum or annuity.
Types
- Defined benefit pension: promises a monthly income in retirement based on a formula, usually years of service times final or average salary times a percentage. For example, 30 years times 2% times a final salary of $60,000 gives $36,000 a year. The employer bears investment risk. Common in government jobs.
- Defined contribution plan: such as a 401(k) or 403(b), where the employee and often the employer contribute to an account, and the balance depends on investments. The worker bears investment risk.
- Cash balance plans: a hybrid with a stated account balance.
- Social Security is separate from employer pensions.
How a defined benefit pension works
The employer contributes to a pension fund, which invests the money. When you retire, the plan pays a benefit for life, sometimes with cost-of-living adjustments. Payment options include a single life annuity (higher payment, ends at death) or a joint and survivor annuity (lower payment, continues for a spouse). Some plans offer a lump sum.
Vesting
Vesting is how long you must work to earn the right to the benefit. Federal law (ERISA) requires pension vesting within 5 years (cliff) or 3 to 7 years (graded). If you leave before vesting, you lose the employer-funded portion. Your own contributions are always yours.
Insurance
The Pension Benefit Guaranty Corporation (PBGC) insures private-sector defined benefit plans. If a plan fails, the PBGC pays benefits up to a limit, around $7,000 a month at age 65 for plans ending in 2024. Public pensions are not covered by the PBGC and are backed by states and cities.
Trends
Private-sector pensions have declined. In 1980, 38% of private-sector workers participated in a defined benefit plan, compared with about 15% today, according to the Bureau of Labor Statistics. Many employers moved to 401(k) plans. State and local governments still offer pensions to teachers, police and firefighters. Some public plans are underfunded, with unfunded liabilities in the trillions.
Taxes
Pension payments are generally taxed as ordinary income, and may be subject to state tax. Rollovers of a lump sum into an IRA avoid immediate tax. Early withdrawals before age 59 and a half usually face a 10% penalty.
Options
Ask your plan administrator for a benefit statement, check vesting, consider the lump sum versus annuity, and plan for spousal benefits. The Pension Rights Center and PBGC help find lost pensions.
Funding and benefit formulas
In a traditional defined benefit pension, the payout is usually calculated as years of service times a percentage multiplier times final average salary. For example, 30 years at 1.5 percent times a 80,000 USD average salary gives 36,000 USD a year. Employers fund plans and invest the money, and private plans are insured by the Pension Benefit Guaranty Corporation, with a 2024 maximum guaranteed benefit of about 7,431 USD a month for a 65 year old in a plan ending that year. Only about 15 percent of private sector workers had access to a defined benefit plan in recent Bureau of Labor Statistics data, compared with about 86 percent of state and local government workers. Most private employers now offer defined contribution plans such as 401(k)s. Pension payments are generally taxable income, and leaving a job before vesting, often 3 to 5 years, can mean losing benefits. Options at retirement include a single life annuity, a joint and survivor annuity or a lump sum.
Based on data from the Bureau of Labor Statistics and the Pension Benefit Guaranty Corporation
