What is Pension and How Does it Work?
A pension is a defined-benefit plan. The plan is “defined” because the employee and employer know beforehand how the pension payout is designed. What is pension income? The simplest answer is “a great deal” if you can take advantage of it.
Usually, a pension involves a fixed monthly payment in retirement. The payment is guaranteed for the life of the recipient.
To a great degree, these plans are being replaced in the workplace by employer-sponsored retirement plans such as 401(k)s. However, there is no guarantee with the most 401(k) choices. A person retiring during a stock market downturn must make decisions about how withdrawals will affect their income. That’s not the case with a defined benefit plan.
Pensions are not completely a thing of the past. They are the norm in public sector jobs.
State and Local Government Pensions
Approximately 83 percent of state and local government employees participate in a pension plan, according to the Urban Institute. Moreover, up to 94 percent of such employees have access to such plans.
In contrast, only 16 percent of full-time employees in the private sector participate in defined-benefit plans. Twenty percent of such employees have access.
What is Pension Extent?
An estimated 5,500 state and local government pension plans exist in the U.S. About 21 million people participate in pension plans. Participants include those still employed in the public sector, retirees and former public employees. Additionally, they have earned benefits but have not started collecting them. Due to escalating pension plan costs, every state has enacted reforms to their retirement systems in recent years.
Pension funds are set up by the employer to pool monies to invest for their employees’ future retirement benefits. Employees do not generally make their own contributions.
Unfortunately, many state and local pensions are underfunded. Such inadequate contributions leave pension funds as much as $1 to 4 trillion in the red.
The IRS does not allow defined benefits plans to retroactively decrease benefits. In some cases, the federal government has bailed out insolvent pension funds.
Pension Benefit Calculation
These benefits are generally calculated by the years of service of the employee multiplied by the final average salary at a specific percentage.
For example, an employee works for their employer for 30 years. Their final average salary is $75,000. With a two percent multiplier, which is a typical standard, their pension is determined by multiplying 30 x 2 percent x $75,000. That equals $45,000. The employee may expect an annual lifetime pension of $45,000. If a higher multiplier is used, that means a larger benefit.
Some pensions are indexed to inflation. Cost of living adjustments are common.
Pension Lump Sum Payment
As the world of pensions continues to change, employees may find themselves offered a lump sum payment option. Instead of the security of a monthly lifetime payment, employers may make this one-time payment available to retirees.
A pension lump sum payment puts the onus on money management to the retiree. With sound financial advice, they could end up making more money with the lump sum option. With unsound investment advice or poor planning, they could end up losing their money. Perhaps the most dangerous possibility is outliving their retirement income.
If offered a lump sum payout, perform careful due diligence. Contact the plan administrator, who should provide you with thorough information about how such a lump sum payout would work.
A Pension Benefit for a Spouse
Many pension plans provide benefits for a spouse and other dependents after the employee’s demise. These are known as joint and survivor payout options.
As per the IRS, the amount paid to the surviving spouse “must be no less than 50 percent and no greater than 100 percent of the amount of the annuity paid during the participant’s life.” There are different rules for beneficiaries who are not the surviving spouse.
What is Pension Withdrawal Age?
Full benefits depend on reaching a specific age, such as 65. The age at which an employee can receive full benefits depends on the individual plan. That doesn’t mean a worker can’t take early retirement. However, if a person takes early retirement at 60 when ineligible for full benefits at 65, they may receive a lower monthly amount.
Pensions and New Jobs
What if you leave your job or are terminated? Unlike a 401(k) or similar employer-sponsored retirement benefit plan, you can’t transfer your pension plan to your new employer. If you have not started taking benefits when you leave your job, you probably can’t take all of the money out of the pension plan. Much depends on the particular pension plan rules.
You may take vested funds out since they belong to you. Keep in mind that vesting schedules vary. In some situations, vesting is immediate. In others, vesting may take as long as seven years of plan participation.
If you lose your job, you could still qualify for a reduced pension. Much depends upon your age and the length of time you worked for the employer.
Besides knowing exactly how much money you’ll receive every month upon retiring, there are other advantages. These include:
- Employers can contribute more than in other forms of retirement plans
- Benefits build up more quickly.
- Insured benefits
- No reliance on fund asset performance
There are downsides to them as well. With a 401(k), you can borrow against your retirement assets to cover emergency medical expenses or your children’s college tuition. You can’t do that with a pension. In addition, they are not inheritable by the heirs of single retirees.
Still, the pros tend to outweigh the cons. Think of it this way. What is pension income? A specific amount of money you can count on every month for the rest of your life post-retirement.
About Jane Meggitt
Jane Meggitt specializes in writing about personal finance. Besides investing and planning for retirement, she writes about insurance, real estate, credit cards, estate planning and more. Her work has appeared in dozens of publications, including Financial Advisor, Zack’s, SF Gate and Investor Junkie. A graduate of New York University, Jane lives on a small farm in New Jersey horse country.