Pension Plan: Definition, Types and How They Work

Pension Plan: Definition, Types and How They Work
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Point Editorial

A pension plan is a specific benefit offered to employees by their employer. The employer allocates money consistently into a separate fund that workers are eligible to draw from once they retire. 

In the United States, most people opt for more specialized plans like 401(k) plans or Roth 401(k) plans instead of generalized pensions. 

Currently, more than 80 percent of individuals working in the public sector and 15 percent of those in the private sector have enrolled in some type of pension plan. 

What is a pension?

While most pension plans require the employer to make regular contributions, some may require additional contributions from employees themselves. The money workers contribute to their pension plans comes directly from their salaries. 

How does a pension plan work?

Pension plans help you to prepare financially for life after retirement from the workforce. There are two different types of plans. 

Defined benefits plan

This plan first started in the 1870s. It guarantees that an employer will pay their employees a monthly payment for life once they retire. 

An employee's earnings and the number of years they worked are the factors that determine their payment amount. If this fails to occur, the company may face legal action. 

When the term "pension plan" is used, it typically refers to defined benefits plans. 

Defined contribution plan

Both 401(k) and Roth 401(k) plans are well-known examples of defined contribution plans. Employers must make specific contributions for every employee, and employees can also contribute to their plans. 

With defined contribution plans, there are restrictions regarding how much workers can add each year and when they can withdraw that money without facing penalties. 

This type of plan is much more affordable for a company overall. That said, more businesses are offering the defined contribution plan instead of the former. 

Some companies extend both defined benefits and defined contribution plans to their employees, though this is rare.

Regardless of their type, pensions are taxable by the federal government. But each of the two plans permits employees to defer those payments until they begin to withdraw funds. 

Pensions versus 401(k) plans

Remember, a 401(k) retirement plan is a distinct type of pension. Their similarities and differences are outlined below in the following table. 

Pension plans 401(k) plans
Guarantees employee benefits in retirement. No benefit guarantees.
Funded by the employer. Employees contribute a portion of their paycheck to build up funds in the plan.
Employees have the option of contributing. Employers can match worker contributions up to a certain amount, or not at all.
Little control over investment options. Greater control over how the money is invested.

Do I need a pension plan or a 401(k)?

The type of pensions available to employees differs from company to company, but employees don't have much say over which type it will be.

In the United States, jobs in the public sector tend to go with a defined benefit plan. The most popular is the 401(k). Nearly 90 percent of public employees participate in this type of plan, according to data gathered in 2020. It is not as common in the private sphere, however.

You may want to consider a defined benefits pension if any of the following apply:

One: You intend to remain with the same company for an extended period. Staying with a single company for many years will ensure that you receive maximum benefits.

Two: You don't plan on moving. Some retirement plans are location-dependent, such as if you're a teacher in a particular state. 

Three: You need income stability in retirement. Defined benefit plans guarantee you fixed payments, which allow you more security. 

In comparison, you may want to consider enrolling in a 401(k) if:

One: You want tax advantages. The money you contribute to a traditional 401(k) is pre-tax dollars, which reduces your taxable income upon retirement. 

Two: You want to switch jobs. A 401(k) is more flexible, should you jump from one position to another or change professional sectors completely. Not to mention that you can transfer what you've saved in the likely event that you change jobs. You don’t need to remain with one company to receive your savings once you retire. 

Three: You can take out a loan. Many 401(k) plans provide you with the option of taking out a loan against that money, which you will eventually repay in the case of hardships or emergencies. 

Can companies change plans? 

Unfortunately, yes, they can. When this happens, employers must compensate their employees accordingly for any work done before that point. The specifics of this type of situation will vary between employers.  

Additionally, if a company goes out of business, declares bankruptcy, or if a large corporation buys them, such actions can trickle down and affect pension plans. Regardless of what happens, employers must notify their employees and provide them with a document that explains all plan modifications. 

Pension plans versus pension funds

Pension plans 

A pension plan refers to a single plan extended to an individual. Plans are more costly than funds, which is explained below in greater detail. Employees have little to no control over the types of investments their money goes toward.

Again, retirement payouts are computed based on an employee's final salary and their years with the company. 

You are not allowed to take out a loan with the plan's money, nor are you allowed to take out your money early. You must be 59 1/2 years or older to withdraw. 

Pension funds

A pension fund is when you amalgamate contributions made by employers and unions. A third party — usually a fund manager — tends to this capital daily by investing it in the stock market. Capital gains taxes do not apply to any earnings generated in this manner.

Monthly annuity or lump sum 

Employees decide what type of payments they'd like to receive. This can come in the form of periodical or monthly annuities or a lump sum. 

Annuities

A single-life annuity means that you will be guaranteed regular payments, usually each month, until death. A joint-life annuity is when pension payments go to the surviving spouse upon the retiree's death. 

Annuities are fixed-rate entities and cannot change over time. 

There is always the risk that a pension plan may run out of money before paying a retiree their total earnings. If this occurs, the Pension Benefit Guaranty Corporation (a government organization whose sole purpose is to take over pension payments if the plans cannot fulfill their obligations) will pay partial amounts of the annuity. 

Lump sums

The most significant advantage of this option is that you don’t need to worry about your pension plan potentially running out of funds down the line. 

Any money that remains from a lump sum payment becomes part of your estate. 

Since it is a single, large payment, you are solely responsible for ensuring the money lasts throughout your retirement.  

Lump sum payments are taxable, and, depending on the volume of your sum, you may move into a higher tax bracket, thus having to pay more to the government. 

Planning for retirement with a pension plan

Described below are three tips for you to consider before preparing for retirement via a pension plan. 

Tip 1: Understand your timeline. The longer you work, the more time you have to build up wealth. You will also have to establish a safety net to invest in riskier things like stocks and commodities. Also, having more money saved will help offset inflation rates.

Tip 2: Review eligibility criteria for each type of plan. If you don't qualify for a specific plan, there's no point in planning and budgeting your life according to its benefits. There are age qualifications as well as rules that say whether you can withdraw payments early or late.  

Tip 3: Outline your goals for retirement. Do you want to travel? Volunteer? Spoil your grandkids? These decisions should also factor into how much you contribute each year and budget your expenses afterward. Ideally, you want enough to live comfortably and happily. 

Point's contributions

The primary purpose of a pension plan is to encourage you to be proactive and save money for the next chapter of your life. A pension is a tool for the long-term, but it's not the only tool out there. 

That said, allow us to introduce Point Card

You work hard for your money, and Point works hard for you in return. Point Card is designed as an alternative yet easy-to-use way of enjoying financial independence. Cardholders can use their own money while receiving exclusive benefits, including unlimited cash-back on all purchases. Point offers fraud protection with zero liability, no interest rates, and rental car and phone insurance, too. These financial safety nets will not only protect the wealth you already have but will aid you as you continue to build it over the short and the long term alike. Point members are also eligible for bonus cash-back on subscriptions, food delivery, rideshare services, and coffee shops.

So, whatever you wish to do in the future, you'll have peace of mind knowing that Point has your back throughout your financial journey.

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