Takeaways
- Defined benefit pensions are an employee benefit that pays guaranteed retirement income.
- Defined benefit pensions are rare for private companies but thrive for public jobs.
- Contributions from employers usually fund defined-benefit pensions.
- The Pension Benefit Guaranty Corporation (PBGS) acts as an insurance fund for pensions.
- Defined benefit pension income can be based on your last years of salary, inflation adjustments, tenure, and title.
What Is a Pension Plan?
A pension plan is an employer-sponsored retirement plan that pays you regular income during retirement. It is an employee benefit that offers you a guaranteed retirement income based on a calculation that takes into account your peak earning years, tenure, title, and other factors.
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How Pension Plans Work
If you have a pension plan, your employer commits to putting aside funds monthly as a future retirement benefit. The amount may be a specific dollar amount or calculated based on your years of employment, title, and tenure.
Once you retire, your guaranteed retirement income payments begin, and you receive monthly payments for the rest of your life. Your company's plan rules may allow your spouse to continue receiving payments after death.
Pension plans have become exceedingly rare among private companies. As of March 2024, only 15% of private companies offered access to defined benefit plans.[1] However, a majority of public sector jobs still offer these employee benefits. In fact, 85% of public jobs still offer access to defined benefit plans.
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Main Types of Retirement Plans
1. Defined Benefit Plan
When people hear "pension plan," they usually think about a defined benefit plan. A defined benefit plan is a specific monthly benefit paid to you by your employer once you retire.
Your employer defines your retirement benefit as a dollar amount. The amount can be a flat rate or calculated based on how many years you worked for the company. Regardless of the type of calculation, with a defined benefit plan, you know how much your pension pays you each month. This benefit type pays from retirement until death.
2. Defined Contribution Plan
A defined contribution plan does not specify or guarantee a specific benefit at retirement. Instead, your employer contributes to a retirement account on your behalf. This contribution amount, usually in the form of 401(k) matching contributions, is typically a percentage of your annual salary.
The money in your defined contribution account is invested and fluctuates in value based on the market. Employees contribute to these plans in tandem with their employer, giving you more control over your retirement funds. These plans are commonly known by the IRS code they reference, such as 401(k), 403(b), 457(b), etc.
Learn More -> What Is a Thrift Savings Plan?
Pros of Pension Plans
- Guaranteed Retirement Income: According to a survey by Allianz, 63% of Americans are worried about running out of money during retirement.[2] A traditional pension plan offers guaranteed monthly income, which reduces the likelihood and fear of outliving one's retirement funds.
- Protected by Law: Federal insurance protects most employer pension plans. Should the company you worked for go bankrupt, PBGC protects your pension up to the federal allowance.[3]
- No Employee Contribution: Workers are not required to contribute to a defined benefit plan to receive retirement benefits. This frees up your income for other uses.
- Spousal Benefit: Some plans continue paying benefits to your spouse even after death.
Cons of Pension Plans
- No Growth Opportunity: Pension plans provide predictable retirement income but do not have the same growth benefits as individually controlled retirement accounts. Your monthly benefit is capped based on your specific pension fund calculation.
- Lack of Control: Your employer controls your pension plan. Typically, you, as an individual, cannot access the money or change how the funds are being invested.
- Costly for Employers: Traditional pension plans are more expensive for employers. Companies with pension plans pay retirement contributions and plan management. This is one of the biggest reasons employers are shifting away from pension plans and opting for defined contribution plans.
- Minimum Service: Pension plan benefits are often calculated by years of employment, incentivizing employees to stick around to earn retirement benefits. Most employers require employees to work with the company for several years before becoming fully vested and eligible to receive pension benefits. You will likely not qualify for benefits if you leave before fully vested. This same risk applies if your company closes or is purchased before you reach your milestone.
Where Pension Funds Invest
Plan administrators and portfolio managers run pension funds. ERISA requires plan sponsors to be fiduciaries of pension plan capital.[4] These fiduciaries include plan trustees, administrators, and members of the plan investment committee.
As institutional investors, pension funds can throw their weight around with the quantum of capital they need to invest. Portfolio managers use both active and passive investing strategies to generate returns with their funds.
Pension plans invest across various asset classes to capture a wide array of risk and return profiles. Traditional investing approaches include publicly traded stocks, index funds, corporate bonds, U.S. Treasury Bills, and REITs.
Pension funds also invest in alternative asset classes. These investments tend to command higher returns (and higher risk) and include cryptocurrencies (e.g., Bitcoin), venture funds, hedge funds, and commodities.
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Pension Plans vs. 401(k)s
Pension plans used to be more popular. According to a Federal Reserve report, 51% of retirees were receiving a traditional pension benefit in 2023. That same report shows that only 21% of non-retirees hold that benefit now.[5]
In the 1980s, pension plans started phasing out in favor of other retirement accounts thanks to changing legislation. After the 1978 Revenue Act, employees were allowed to contribute pre-tax dollars towards their retirement. Employers began shifting the cost of paying for retirement away from themselves and onto employees.
401(k)s offer flexibility and control for employees that pension plans do not. With a 401(k) plan, you choose how you invest your money and how much you invest. You can also borrow from your account with a 401(k) loan or withdraw the funds early, although you may incur tax penalties.
Read Also: Average 401(k) Balance by Age
Smart Summary
Pension plans are defined benefit plans private and public companies offer employees, paying them a guaranteed income during retirement. According to the Bureau of Labor Statistics, as of March 2024, 91% of companies with 500 or more employees offer retirement plans.[6] If you have a pension plan as part of your retirement benefits, you are in the minority. Even without a pension or other employer-sponsored retirement plan, you can use tax-advantage accounts to fund your retirement.
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Frequently Asked Questions
Pension benefits begin once you officially retire. From there, you will receive your guaranteed retirement income. Some retirees even start a side hustle or advance to another career once their pension benefits begin.
Employer-sponsored 401(k) plans have taken over the traditional pension plan in the private sector. Only 15% of private companies offer pension plans to employees.[6] Pension plans are expensive for smaller private companies, and 401(k) plans allow the employer and employee to share in the employee’s retirement savings. (Read about 401(k) matching contributions).
Employer-sponsored 401(k) plans give savers much more flexibility in investing options than pension plans. You can direct where you want to save money and calibrate your 401(k) holdings to align with your overall investment portfolio. You can work with a financial advisor or robo-advisor to help this process.
(1) Bureau of Labor Statistics. Retirement benefits: Access, participation, and take-up rates for defined benefit and contribution plans. Last Accessed January 13, 2025.
(2) Allianz. Nearly 2 in 3 Americans Worry More About Running Out of Money than Death. Last Accessed January 13, 2025.
(3) Pension Benefits Guaranty Corporation. About PBGC. Last Accessed January 13, 2025.
(4) U.S. Department of Labor. Fiduciary Responsibilities. Last Accessed January 13, 2025.
(5) Federal Reserve. Report on the Economic Well-Being of U.S. Households in 2023-2024. Last Accessed January 13, 2025.
(6) Bureau of Labor Statistics. Employee Benefits in the United States March 2024. Last Accessed January 13, 2025.
