How a Pension Works

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Planning for retirement should start when you’re young. In the old days, it was started for you by your employer. But now that employee benefit of a pension plan has become a rarity. Yet just because it’s rare, doesn’t mean it’s nonexistent. And although most pension plans are held in the public sector, millions of people in the private sector still have them.

Most traditional pension plans have moved over to other forms of retirement planning. But it’s still important to know how pension plans work and what your options are.

Employee Retirement Income Security Act

Pension plans come under the U.S. Department of Labor, specifically the Employee Retirement Income Security Act (ERISA). Established in 1974, ERISA sets minimum standards for most voluntary retirement and health plans in private industry. It provides protection for individuals who participate in these plans.

The act provides fiduciary responsibility for those who manage and control plan assets. Other ERISA benefits include:

• standardize vesting
• benefit accrual
• funding

It gives participants the right to sue for benefits and breaches of fiduciary duty.

Generally, ERISA does not cover plans established and maintained by churches and their employees or governmental entities.

Types of Pension Plans

A pension plan involves the employer making regular contributions to a pool of money. This money is set aside to fund payments to eligible employees when they retire.

There are two types of pension plans: the defined-benefit pension plan and the defined-contribution pension plan.

With a defined-benefit plan, an employer makes all the contributions to the pension fund. It is a guarantee that the employee will receive a monthly payment after retirement: a lifetime benefit. The defined benefit to the employee must be legally paid despite the investment fund’s performance.

The retiree’s payment amount is based on earnings and years of service.

The defined-contribution plan is when the employee makes contributions. The employer may match some or all of these contributions, but it is not required to do so.

The future benefit to the employee depends on the plan’s performance. That means the company’s liability ends once contributions are made.

The 401(k) and 403(b) plans are examples of a defined-contribution plan. The defined-contribution plan is a less expensive way for a company to sponsor a retirement plan.

The company isn’t liable for additional costs beyond agreed contributions.

Pension Plan Variations

Some companies offer both defined benefit and defined-contribution retirement plans. These companies will allow employees to roll over their 401(k) balances to the defined-benefit plan.

The last form of pension plan is the “pay as you go.” Current employees make contributions to fund the plan. They can take salary deductions or contribute lump-sum contributions. Their contributions actually pay for the retirees, and then the next group of employees pay for them.

A classic example of pay-as-you-go is Social Security.

When Do You Receive a Pension Payment?

Qualifying for a defined-benefit pension plan depends on how many years the employee works for the same employer. Once you qualify, it’s called vesting. There are two types of vesting schedules.

The first is the cliff vesting schedule. This schedule gives you 100 percent of the earned benefit in a designated year. The year could be when you’re 50 or when you’re 65. The plan/employer can choose any year.

The second form of vesting is a graded schedule. It means the participant is entitled to a certain percentage of the earned benefit the longer you work.

For example, for a seven-year for a seven-year graded schedule, you would receive:

• 20 percent the third year
• 40 percent the fourth year
• 60 percent the fifth year
• 80 percent the sixth year
• 100 percent the seventh year

You may note that you weren’t vested for the first two years. So, it’s in your favor to work longer for the company.

Can an Employer Terminate a Pension?

A company that offers a pension has the right to terminate it. When this occurs, accrued benefits are frozen. But you’ll receive all the earnings up to the point of termination.

Although you’ll receive these earnings, there is no more accumulation for additional pension income.

Are Defined-Benefit Pensions Taxed?

You are not taxed on a defined-benefit pension until you start receiving payments. Distributions to you from the pension fund are considered ordinary income, just like your paycheck was.

An early withdrawal of your pension will result in a distribution penalty. And if you wait to retire but don’t take out the required minimum distribution, you'll have a penalty.

Are There Spousal Benefits?

Pension plans are required by ERISA to provide benefits to a decedent’s living spouse. This protects spouses from losing ongoing retirement benefits. The benefit percentage is different for each plan.

The spouse’s payment may be equal to 100 percent of the decedent’s payment. But the most common scenario is 50–75 percent of the deceased payment.

401(k) Takes Place of Employer Pension Plan

In 1970, 26.3 million people, or 45 percent of private-sector employees, were covered by employer pension plans. Today, pensions have mostly survived in the public sector and some unionized companies.

In 2023, there were 70 million active participants in 401(k) plans. That figure doesn’t count the millions of former employees or retirees with plans.

If you have a defined-benefit pension, ensure you know your rights through ERISA.

But if your company doesn’t offer a defined-benefit pension plan, inquire about a 401(k). It may be your best option to save money for the future.

The Epoch Times copyright © 2024. The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.