What is a pension? It’s a question few workers would have asked a generation ago, when pensions were the most common type of retirement plan.
Today, pensions have largely been replaced by the 401(k). Only 22 percent of Americans have pension plans, with the majority of pensions offered by government agencies.
A pension guarantees a monthly income after retirement. Unlike a 401(k), where the employee contributes toward their own retirement savings, a pension plan is funded by the employer.
This explains, in part, why many companies have switched from pension plans to 401(k) plans — the 401(k) is a cheaper option for employers.
The exact amount an employee receives from a pension depends on their years of service, age and annual salary. Employees value pension plans as they cost the employee nothing, freeing up employee money for other types of retirement plans, such as IRAs and mutual funds.
Four types of pension plans
Here are the four types of pension plans most often seen in the United States:
Personal pension plan: A private plan made up of contributions by the pension holder. You can invest money contributed to a personal pension in a range of assets. Upon retirement, the plan owner can take the pension as a lump sum, leave it invested in the plan and withdraw cash as needed, or use the plan’s funds to purchase an annuity.
Annuity: In this special type of insurance plan, the plan holder makes regular payments to the insurance company or purchases the annuity as a lump sum. Upon the plan holder’s retirement, the insurance company pays a guaranteed amount for a set period or until the policyholder’s death.
Employer-sponsored pension plan: A plan offered by a private corporation that can contain anything from retirement savings to health care benefits. Employees can get discounts, and employers can get tax breaks.
What is a defined contribution pension plan?
The four types of pension plans listed above are increasingly being replaced by defined contribution pension plans such as 401(k)s and IRAs.
With a defined contribution pension plan, the employee chooses how much to contribute to the plan. That contribution is deducted from the employee’s paycheck prior to taxation, and the money accrues tax-free until it is withdrawn.
Employers may choose to contribute to or match employee contributions to these plans.
What are the advantages of defined contribution plans?
While defined contribution pension plans cannot guarantee how high your investment return will be, they can be an effective way to save for retirement. Check out these advantages:
- You have more control over which assets to invest in.
- Plans are easily transferred should you move to another company.
- There is potential for higher returns than with other pension plan types.
- While other pension plans favor employees with seniority, defined contribution pension plans allow employees to benefit as soon as they start to contribute to the plan.
How do pensions work after death?
If you have a spouse or children, it’s important to understand how pensions work after death. Check your pension plan carefully. Many traditional pension plans will make payments to surviving spouses or dependent children after death, but others do not.
If you have a defined contribution plan such as a 401(k), the funds in the account become part of your taxable estate upon death.
The bottom line
Your pension plan choices will typically be limited to the type of plan your employer offers. Whether you have access to any of the four types of pension plans, defined contribution pension plans, or some other type of retirement plan, understanding your plan and the nature of its investments will help you successfully prepare for retirement.