Pensions: What They Are And How They Work

What Is A Pension?

In general, a pension represents supplemental income in retirement. A pension plan is a vehicle or program that enables that to happen by setting money aside and investing it during an employee’s working years. Large public and private sector employers commonly have pension plans set up to provide for their employees in retirement.

There are two types of retirement plans: defined benefit plans and defined contribution plans such as 401k plans and 403b plans. Nowadays, when people talk about pension plans, they are referring to the traditionally defined benefit plans. From this perspective, pension plans are prevalent in the public sector for groups such as teachers, municipal workers, and government employees, while corporations have been moving away from defined benefit plans in favor of 401k plans where the funding responsibility falls to the employee.

Note: In addition to employer pension plans there are special purpose pension plans such as disability plans that may be funded by government agencies.

How Do Pensions Work?

Employers with traditional pension plans set aside money each year for all employees in the plan, aggregating the money into a single pool, which is then professionally invested. As employees retire, they elect a distribution option and are paid from the pool. Employees have no say as to how the money is invested but are kept informed at least once per year of the plan’s overall financial status.

Pensions are often designed to provide employees with a lifetime income at retirement that can be as high as 50-75% of their pre-retirement income, thereby providing a significant benefit. However, if an employee with a pension leaves their employer before qualifying for the maximum benefit, they could receive significantly less or potentially no benefit at all.

In addition, pension plans are not transferable since the money is part of the overall pool. As such, one cannot transfer their benefit to a different employer or roll it into an IRA like they can do with a 401k.

Public Vs. Private Pensions

There are both public sector and private sector pension plans. They generally work the same way but are governed by different laws. A public school teacher’s pension fund, for example, would be governed by state legislation and its contributions are made from state funds, whereas a corporate pension plan is governed by corporate law and the contributions are made from company’s earnings.

Pension Fund Regulations

Pension plans are governed by a combination of state and federal regulations in addition to rules issued by the Internal Revenue Service and the Department of Labor. Laws and regulations address issues of responsibility and accountability, reporting, investing, eligibility, and the rights and benefits of plan participants.

As an example, the Pension Reform Act of 2006 closed loopholes that allowed companies to skip payments, required underfunded plans to pay higher premiums to the Pension Benefit Guarantee Corporation (which insures workers against losing their pensions in a bankruptcy), and gave workers greater control over how their plans were invested, among other things.

How Pension Money Is Invested

Overall, pension funds are invested conservatively and for the long-term, primarily using stocks, bonds, mutual funds, and real estate. Most will have a written investment policy statement that their investment managers are obliged to follow and that their trustees have approved.

Pension Vesting Schedules

Employees generally become eligible to participate in their employer’s pension plan at, or shortly after, they begin employment. At that point, the employer begins contributing money on their behalf, but they likely won’t have the right to that money immediately. Employers commonly require that employees put in a minimum number of years of service before having full rights to their pension funds.

The schedule of how long an employee must work before having full rights to their accrued pension funds is called a vesting schedule and there are ‘graded’ vesting schedules and ‘cliff’ vesting schedules.

Cliff Vesting

A cliff vesting schedule makes you fully vested (meaning you have 100% rights to accrued funds) upon working for your employer for a minimum number of years. A cliff vesting plan might award employees full vesting after say five years. Federal law mandates that cliff vesting cannot exceed five years, but allows employers to vest workers sooner if they so choose.

Graded Vesting

A graded vesting schedule vests employees in stages. Private sector graded vesting schedules typically vest an employee as follows:

• After 3 years: 20% vested
• After 4 years: 40% vested
• After 5 years: 60% vested
• After 6 years: 80% vested
• After 7 years: 100% vested

As with cliff vesting, employers are permitted to vest employees sooner if they desire.

Types Of Pension Payment Schedules

When an employee retires, they will have various options on how to receive their funds from the pension plan. Distribution options include the following:

• Lump-sum – The plan pays a single one-time payment at retirement. This may be tempting, but will also result in a big tax bill unless rolled into an IRA.
• Period Certain – This option pays the employee over a set period of years, say 10 years. If you do not survive the period, the remainder goes to your beneficiary.
• Single-Life Annuity – Annuitizing the payout will produce an income for the retiree’s life. Payments cease, however, when the retiree passes and do not go to a beneficiary.
• Joint Survivor Annuity – The retiree can annuitize and stipulate that when they die, payments continue to a surviving spouse, at which point the payments will continue for the remainder of the spouse’s life. Payments under a joint survivor annuity will be accordingly lower than for a single-life annuity.

Tip: Once a payout plan is selected, it cannot be changed. Therefore, retiring employees should carefully consider their financial needs, tax situation, and their general health and life expectancy when deciding on a payout option.

Types Of Pensions

Pension plans can be either defined benefit or defined contribution plans. In a defined benefit plan, the employer makes all the contributions. In a defined contribution plan, the employee makes most of the contributions, and the employer may offer an employee match or add contributions from profits but is not obligated to do so.

1. Defined Benefit Plan

In a defined benefit plan, the employer commits to providing a certain level of retirement benefits to eligible employees and contributes a sufficient amount of money into the plan each year to provide that benefit. The plan’s assets are pooled for all eligible employees and the amount of each year’s contributions is determined by a complex analysis that projects the number of employees who will ultimately retire, the amount of their collective benefits, their life expectancy, and expected returns on professionally-managed investments.

2. Defined Contribution Plan

In contrast, a defined contribution plan such as a 401k plan, allows each employee to contribute voluntarily and manage the investments themselves. The ultimate benefit in defined contribution plans is therefore determined by how much the employee is able to contribute and how well they invest the funds. Employers can add to or match employee contributions if they elect to, but most of the assets in defined contribution plans come from the employee.

Paying Taxes On Pension Plan

Pension contributions are made on a pre-tax basis, whether they are made by the employer or the employee. That means all distributions are taxable as ordinary income when they are received. Taxes cannot be avoided, but they can be deferred if the payout is rolled into a qualified IRA or 401k plan.

How Pension Funds Work If You Quit

If you are participating in a pension plan and you leave that employer, there are several possible scenarios:

• If leaving a defined benefit plan, your plan may allow you to take a lump-sum distribution on the money you are vested in and roll it into an IRA. Otherwise, you must leave your vested funds there until you reach the eligible retirement age. Any accrued money that is not yet vested is forfeited when you terminate employment.
• Money you contributed into a defined contribution plan is always fully vested because it was your money to begin with. You can generally leave it in the plan after you terminate employment and withdraw once you reach eligible age, or take a lump-sum distribution. Any distribution will be fully taxable as ordinary income unless you roll it into an IRA or into a defined contribution plan at a new employer.

Employer Termination Of Pension Plan

When an employer terminates a pension plan, they must verify that the plan is sufficiently funded to meet its future expected liabilities at the current point in time. (This prevents a company from terminating a plan to avoid a funding deficiency).

The company must then make all participants 100% vested immediately. That doesn’t require adding money but means eliminating the vesting schedule so that recently-hired employees are now all 100% vested. Then the company can make all participants aware of the termination and let them know their options. Some might be old enough to take a lump-sum distribution while others may elect to roll their assets to another qualified plan.

Trends In Pensions In Recent Years

Some pension plans are still climbing out from the carnage they suffered during the market crash of 2008. The Butch Lewis Emergency Pension Plan Relief Act of 2021 was signed into law to forestall the insolvency of approximately 100 multi-employer pension plans that were projected to run out of money over the next 20 years.

Other trends include continuing terminations of corporate pension plans in favor of 401k plans that protect shareholders from having to use corporate profits to shore up plans that cannot meet growing liabilities. According to the Dept. of Labor, the total number of defined benefit pension plans in the US declined to 46,869 in 2018 from 113,862 in 1990.