After months of looking, you have just landed a new job, complete with an employee benefits package. After reviewing the paperwork, you realize the company offers both a 401(k) and a pension plan. While you may be familiar with 401(k)s, you may not fully understand pension plans and how they work.
Definition of a Pension Plan
A pension plan is a type of retirement account funded by your employer on your behalf. The employer invests contributions so you can receive payments later. These payments are designed to provide income in retirement. Before signing up, take some time to review the basics of pension plans. Learning how they work can help you make informed decisions about your retirement.
Pension Plans vs. 401(k)s
Key Differences at a Glance
| Feature | Pension Plan (Defined Benefit) | 401(k) Plan (Defined Contribution) |
|---|---|---|
| Who Contributes | Employer | Employee, with possible employer match |
| How Benefits Are Paid | Lump sum, monthly payments, or both | Based on contributions and investment performance |
| Responsibility | Employer manages contributions | Employee chooses contribution amount |
| Withdrawal Rules | Set by plan | Subject to rules and early withdrawal penalties |
How Each Plan Works
- Pension Plans (Defined Benefit Plans): Your employer contributes to the plan and promises a set benefit in retirement. Payments may be a lump sum, monthly income, or a combination. Check your plan details for specifics.
- 401(k) Plans (Defined Contribution Plans): You contribute a portion of your pay. Your employer may match part of your contribution. These plans have rules for withdrawals, including penalties for taking money out early.
What Happens When You Change Jobs
When you leave your employer while enrolled in a defined contribution plan, you can either cash out the plan or roll over your account funds into a new individual retirement account (IRA) or 401(k). With a pension, the money typically stays in the plan. However, if the pension plan offers payment in the form of a lump sum, you may have the option to roll it over.
Fully Vested Interest
When you are fully vested in your employer’s pension plan, you are entitled to receive 100% of the promised benefit. You usually need to complete a certain number of "hours of service" over a set period before you become fully vested. Your employer will likely follow a vesting schedule, which may be a cliff vesting schedule or a graded vesting schedule.
Cliff Vesting Schedule
Cliff vesting means you become fully vested after working for your employer for a set number of years. For example, your company may require you to stay for at least five years. If you leave before that time, you could lose 100% of your pension benefits.
Graded Vesting Schedule
With a graded vesting schedule, you earn ownership of your pension benefits over time, based on your employer’s schedule. For example, you may be entitled to 20% of your benefits after two years of service and become 100% fully vested after six years.
Some plans allow you to begin earning "hours of service" right away, while others may require you to work for one year before these hours begin to count. In many cases, one year of service equals 1,000 hours.
Payouts from Pension Plans
The payout you receive from a pension plan is generally based on the following:
- Percentage (%) of your pay x number of years you worked at your company
If you have a higher salary and have been with your employer longer, you will receive a higher payout.
Payouts Differ by Age
Depending on the plan, your monthly payment amount can vary based on when you begin taking payments. Your pension plan sets the age at which you are eligible to start receiving payments.
For example, you may be eligible to begin receiving payments at age 55. However, monthly payments at age 55 may be lower than if you wait until age 60. Payments may be even higher if you wait until age 65.
These monthly payments continue for the rest of your life once they begin. Depending on the plan, you may have the option to take the payout as a lump sum or as an annuity, which provides a steady stream of income during retirement.
The Annuity Option
While what's offered depends on the pension plan, there are three common types of annuities:
- Single Life Annuity: This option provides the largest monthly payment, but payments stop when you pass away.
- Joint and Survivor Annuity: You receive payments for your lifetime. After your death, your spouse or a named beneficiary continues to receive payments. This may be a good option if you want to help cover your spouse’s living expenses.
- Period Certain Annuity: This option guarantees monthly payments for a set period, such as five or 15 years. If you pass away before the period ends, the remaining payments go to your beneficiary. For example, if the period is 20 years and you receive payments for 10 years, your beneficiary will receive payments for the remaining 10 years.
The Bottom Line
Pension plans are less common today and may continue to decline. If your employer offers a pension plan, take time to understand how it works, how it compares to other retirement plans, and how it may fit into your retirement savings goals.
