What Is a Pension?

A pension is a benefit plan that can provide a fixed income in retirement.

Written by Devon Delfino / July 13, 2022

Quick Bites

  • Pension plans typically offer a set amount of monthly income in retirement.
  • Unless it’s a government pension, you may not even have to contribute to it. Your employer could be the sole contributor.
  • You will, however, pay taxes on that money once you start receiving those funds.

For a lot of people, the idea of a pension plan can seem like a relic from a bygone era. But pension plans still exist, and if you’re in a position to access one, it can be a valuable tool. But, like any financial tool, you should know how it works first. Here’s a breakdown.

Inside this article

  1. Pension definition
  2. How do pensions work?
  3. Are pensions taxed?
  4. Is it worth paying into?
  5. Types of pensions
  6. Pensions vs 401(k)
  7. Example

What is a pension?

A pension is a benefit plan that provides retirement income and is maintained by an employer, or an organization like a workers’ union.[1]

“A pension plan is a form of employer-sponsored retirement plan that was first established in 1875 by the American Express Company,” says Kristina Keck, vice president at Woodruff Sawyer, a risk management and employee benefits company. “Pension plans have been in decline since the late 1990’s with the number of Fortune 500 companies offering pension plans declining by over 80%.”

Why the change? There was the advent of the 401(k), but there were also modifications in laws that mandated that private pension plans have more money on hand, among other things, including increased complexity and volatility. That made maintaining pensions much less interesting for companies.[9]

How do pensions work?

In general, when you work for an employer that offers a pension plan, you’d become eligible to receive a set amount of money paid out to you throughout your retirement. Typically, you have to work for a company for a certain amount of time to be eligible for a pension. For example, you may often see options that require a minimum of five to seven years of service. Assuming you meet those requirements, you can collect a pension from more than one employer.[2]

Pension plans can be funded by both employee and employer contributions—similar to a 401(k)—however, some pension plans (like those from private companies or through unions) are funded solely with employer contributions. Government pension plans may require employee contributions. An employee’s pension payment in retirement is determined by the worker’s age and their annual income they earned prior to retirement. So, the longer you stay with the company, the bigger the pension payment in retirement. You can figure out how much that payment would be by requesting an individual benefit statement from your employer.[3]

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Contributions to a pension plan are pooled and then invested, allowing them to grow in value over time.[4] This way pensions can provide consistent payments, like you’d get with an annuity, throughout retirement.

“Many participants in pension plans may assume that the pension plan will be a permanent piece of their retirement package,” says Keck. “However, as funding pension plans can be a strain on a company’s budget, many pension plans in the US today are ‘frozen,’ meaning that new employees are not eligible for the pension and existing participants' benefit payments are frozen.”

Are pensions taxed?

Yes. Like any retirement plan, there will be taxes required for those who have a pension. So you’d owe federal taxes that would be determined based on your income tax bracket at retirement. It’s worth noting, however, that you can take your pension as a lump sum payment. In that case, you’d pay the total tax due that year.[5] On top of that, though, you may also owe a 10% penalty if you get that lump sum before age 59 ½ (just like with a 401(k)).[6]

Either way, your employer will withhold taxes from your pension payments, so you wouldn’t have to make estimated tax payments based solely on that income.[5]

Is it worth paying into a pension?

Having a pension can provide some much-needed stability in retirement since you can have equal disbursements each month and it doesn’t even require you to make contributions. That can help you plan ahead in retirement, and manage your finances with confidence. But you have to be willing to stay with your employer long enough to qualify, and then your payment amount would be determined by your tenure there. So whether or not it’s worth it will depend on your needs and ability to commit to your employer.

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Types of pensions

“Most pension plans are defined benefit pensions designed to guarantee a retirement income benefit based on your age and salary prior to retirement,” says Keck. “Defined benefit plans have been in decline due to the cost in maintaining the plan and providing the income benefit to employees throughout their retirement. The employer is responsible for the overall management of the investments, not the employee.”

These are the plans that we’ve discussed in detail above.

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There are also defined-contribution pension plans. Unlike defined-benefit plans, these guarantee contributions rather than your retirement payments. And these would usually require both the employee and employer to make contributions. Your retirement payments would be based on market performance.[7]

Pensions vs 401(k)

Let's look at a side-by-side comparison of pensions versus 401(k)s.

Pensions401(k)
Who contributes? EmployerEmployee (employer may match)
Guaranteed monthly check?YesNo
Control over contributions?No Yes
AvailabilityIncreasingly rareVery popular

Example

Let’s say you’re 24 years old and your employer contributes 5% of your $70,000 salary to a pension plan. The pension is also credited with 5% interest every year. That would mean adding $3,500 in contributions, plus $175 in interest, per year. By the time you were 67 years old, that would come to just over $500,000 in contributions and interest. That assumes that you don’t get a raise at some point, but you stay with that employer the entire time.

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Again, your payment would be based on your income at retirement and how long you stayed with the company. So it’s difficult to say how much such contributions would translate to. But if you have access to a pension plan, you can find out how much to expect in monthly payments by contacting your employer or the organization that manages your pension plan.

Article Sources
  1. “Retirement Plans Benefits and Savings.” U.S. Department of Labor. https://www.dol.gov/general/topic/retirement.
  2. “What is a Pension?” Pension Benefit Guaranty Corporation. Feb. 26, 2021. https://www.pbgc.gov/about/who-we-are/retirement-matters/post/2013/04/17/What-is-a-Pension.
  3. “Pension and 401(k) / 403(b) Plans.” Legal Aid At Work. https://legalaidatwork.org/factsheet/pension-and-401k-403b-plans/.
  4. “Investment.” National Association of State Retirement Administrators. https://www.nasra.org/investment.
  5. “Taxation of Retirement Income.” FINRA.org. https://www.finra.org/investors/learn-to-invest/types-investments/retirement/managing-retirement-income/taxation-retirement-income.
  6. “Pension lump-sum payouts and your retirement security.” Consumer Financial Protection Bureau. https://files.consumerfinance.gov/f/201601_cfpb_pension-lump-sum-payouts-and-your-retirement-security.pdf.
  7. “2 main types of pension plan.” Ontario Securities Commission. https://www.getsmarteraboutmoney.ca/plan-manage/retirement-planning/pension-savings-plans/2-main-types-of-pension-plan/.
  8. “Understanding the difference between a pension plan and a 401(k) plan.” Protective Life Insurance Company. ​​https://www.protective.com/learn/understanding-the-difference-between-a-pension-plan-and-a-401k-plan.
  9. “WHAT HAPPENED TO PRIVATE SECTOR PENSIONS?” National Public Pension Coalition. Aug. 4, 2016. https://protectpensions.org/2016/08/04/happened-private-sector-pensions/

About the Author

Devon Delfino

Devon Delfino

Devon Delfino is a writer who’s covered personal finance—including everything from student loans to budgeting to saving for retirement and beyond—for the past six years. Her financial reporting has appeared in publications like the L.A. Times, U.S. News and World Report, Teen Vogue, Masha

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