A pension plan is essentially a retirement plan that is provided by your employer. Unlike a 401(k), you do not have to contribute to the plan in order to receive distributions. Instead, your employer funds your pension plan.
Pension plans initially became popular during World War II. After Congress passed the Stabilization Act of 1942, the president was able to freeze salary increases for employees across the country. President Franklin Roosevelt immediately used these powers to stop employees from getting additional raises, bonuses and commissions.
Because of World War II, the demand for labor was growing at an unexpected rate. This was causing wages to increase rapidly. The government designed the law to help the war effort. A small clause in the law is the reason why we have pensions and employer-sponsored insurance today. Despite the ban on raises, this legal clause allowed health insurance and pension benefits to grow.
Savvy companies expanded their pension plans in order to attract workers. Because the Revenue Act of 1942 also taxed profits at rates of 80 to 90%, corporations also used pension plans as a way to avoid taxes. Instead of giving money to the government, they could give their employees extra benefits. By the end of 1960, pension plans covered about 23 million people. This meant pension plans covered roughly half of employees in the private sector. Today, only 21% of workers are covered by a pension plan.
What Is a Pension Plan?
In the private sector, defined contribution plans typically replace pension plans. If you work in the public sector, there is a good chance that you can still use a pension plan to prepare for retirement. With a pension plan, your employer sets aside money for your retirement. Over time, these savings grow because of compound interest and dividends.
Upon retirement, you are able to get regular payments from your pension plan or a lump sum. With some pension plans, your children or spouse can even inherit the remainder of your pension benefits. These benefits are generally based on your tenure with the company and your salary. For example, you may only receive 50% of your salary in retirement if you only worked at the company for 10 or 20 years. If you worked for the company for 40 years, you might get 85% of your salary covered during retirement.
To receive your pension benefits, you have to stay with your employer for a set amount of time. If you quit your job before your pension has vested, you will not get any money out of your pension account. Additionally, pensions may use graded or cliff vesting. Graded vesting is where a percentage of your benefits vest each year. Eventually, your pension is vested 100%. With cliff vesting, you will not get any of your pension benefits until a set amount of time has gone by.
Employees do not control pension plans, which can be a good thing. It can also be an issue because you have no control over whether your employer properly funds your plan or not. While your employer should set aside money each year to fund your plan, this does not always happen. In addition, if a company goes bankrupt, it can terminate your pension plan.
How Much Risk Is There?
Any retirement plan will carry some degree of risk. You do not have control over your pension plan, so your company can invest the funds in risky stocks or bonds. Your company could also go bankrupt. Over time, it may adjust the terms of your pension plan. For example, some pensions have dropped the salary percentage that they give to retired employees. Because pensions are so expensive, employers will often try to minimize the cost of these plans.
Even if the company goes bankrupt, you should still get some money out of your pension plan. Instead of receiving pension payments from your company, you will get them from the Pension Benefit Guaranty Corporation. Unfortunately, you will most likely see a reduction in benefits.
Every type of retirement plan comes with some degree of risk. Because of this, it is important to save for retirement through multiple techniques. Ideally, you should also have other retirement savings available to supplement your pension if something goes wrong.
Can You Get Social Security Payments With a Pension Plan?
If you are a government employee, you may receive pension benefits instead of Social Security benefits. Depending on the pension amount you receive, you may also receive partial benefits from Social Security. Many workers in the public sector do not have to pay payroll taxes to Social Security, so they do not get Social Security benefits when they retire.
There is also a rule in place known as the Social Security Windfall Elimination Provision (WEP). It will limit how much money you can get once you retire. If you worked in the private sector and the public sector, WEP will limit how much you can get through Social Security benefits. In addition, the Government Pension Offset (GPA) will limit how much you can get through survivor or spouse benefits if you are also eligible for a government pension.
Ultimately, the goal of WEP and GPO is to save the government money. When your Social Security benefits are calculated, your years in the public sector are treated like you earned nothing because you did not pay Social Security taxes. Because Social Security is calculated from 35 years of your work history, your Social Security benefits will probably be quite limited. Fortunately, your pension benefits should be enough to cover the difference.
How Do Pensions Differ From 401(k) Plans?
If you work in the private sector, your employer most likely offers a 401(k). With a 401(k) plan, you contribute a set percentage of your salary to the plan each month. Many employers will offer matching contributions up to a certain limit.
Unlike a pension plan, a 401(k) allows you to choose how your funds are invested. If you know a lot about investing, you could end up earning more money with a 401(k) than you would with a pension. You are also more likely to lose all of your money because you could make bad investment decisions. In comparison, your employer is required to pay your pension. Even if your employer makes a bad investment, you will still get your pension benefits.
Pensions and 401(k) plans are tax-advantaged ways to save for retirement. You do not pay taxes on your contributions until you retire. Once you begin taking your pension benefits or 401(k) distributions, you will have to pay taxes. If you decide to withdraw your pension through a lump sum, you will need to roll it over to an individual retirement account (IRA) unless you want a huge tax bill.
While you can get private pensions, many public organizations like the federal government also offer pension plans. Old companies still offer pensions, but many of these organizations are trying to limit pension programs as much as possible. These programs tend to be extremely expensive to run, and the Pension Benefit Guaranty Corporation requires employers to insure their programs. Because of the high costs, many private companies are working to phase out their pension plans.
About Ben Broadwater
Ben Broadwater is the Director of Investment U. He has more than 15 years of content creation experience. He has worked and written for numerous companies in the financial publishing space, including Charles Street Research, The Oxford Club and now Investment U. When Ben isn’t busy running Investment U, you can usually find him with a pair of drumsticks or a guitar in his hand.