Center for a Secure Retirement
How Do Pensions Work Before and During Retirement?

How Do Pensions Work Before and During Retirement?

A pension is a workplace retirement plan that promises income for life. Not all employers offer pension plans, and to qualify for benefits, you usually need to meet specific requirements.

As you evaluate your employer's benefits, absorb as much information about them as you can. Ask your employer: How do pensions work, when can you start collecting income from them, how much will you receive and can you start withdrawing from your pension before retirement? While every plan will be different, let's go over the basics to get you started.

How Do Pensions Work?

Pension plans promise to pay you a retirement income based on your work history with your employer. For example, your employer might pay you several hundred dollars — or several thousand dollars — each month after you retire. These plans are also known as defined benefit plans because the plan specifies exactly what you'll receive after retirement.

Pension calculations often include the number of years you worked — the longer you've worked for your employer, the more retirement income you'll receive. Your earnings history is important, too: Pension plans sometimes calculate your monthly income based on your three highest yearly salaries or your salaries during your final three years on the job. Bigger is better here, too — the more you earned, the more your pension will pay out.

How Long Do Pensions Last?

Once you start taking benefits, it might feel as though you're still drawing a salary. That's because your pension plan usually pays you a monthly stipend that replaces what you earned when you were working. And it usually provides income for the rest of your life, however long it is.

But what happens if your employer goes bankrupt or is unable to pay pension benefits? Some pension plans are protected by the Pension Benefit Guaranty Corporation (PBGC), a federal safety net created by the Employee Retirement Income Security Act. If your pension plan fails and it's protected by the PBGC, the PBGC steps in, and your payments continue.

However, the PBGC sets maximum monthly limits, so you might not receive the full pension your company promised. Some pension plans are not covered by the PBGC; if you're concerned about your employer's financial stability, ask whether its pension plan is protected by the PBGC.

Including a Pension in Your Financial Legacy

When you retire, you'll have to make several choices that affect your monthly income and your family. One of the most important choices is whether you want a survivor to continue receiving payments after your death. If your pension income is a significant piece of your household income in retirement, this is an important choice.

Pension plans usually offer one of three options for beneficiaries, and each affects your monthly payout.

  • No survivor benefit: If you don't include a survivor benefit, the pension income lasts for your life, and it ends when you die. This typically nets the highest monthly income, but it only lasts as long as you live.

  • 50% survivor benefit: If you want to protect your spouse, you could have the pension continue paying half of your monthly income to them after you die. This option slightly reduces your monthly income, but it reduces the risk of your spouse facing financial hardship.

  • 100% survivor benefit: The safest option for your survivors is to choose a 100% survivor benefit. With that option, the pension income does not change after your death, so family members can expect to continue receiving the full amount each month. This choice results in a smaller monthly income than the 50% survivor benefit because it provides more value to survivors.

How Do Contributions Work?

Pension plans are primarily funded by your employer. But public sector employees often contribute to their pension plans, and state statutes or other mandates generally set the amount they can contribute. Employees of privately owned companies are less likely to contribute to a defined benefit plan.

When you contribute to a pension, you usually contribute a certain percentage of your pay. According to the National Association of State Retirement Administrators, employee contribution rates are typically between 4% and 8% of their pay. Your employer handles the investments once the money goes into the plan.

In most cases, your pension income is taxable. Set aside a portion of your income or tell your employer to withhold a portion; doing so can ease the burden when you file and pay your taxes.

What Is Vesting?

You might come across the term "vesting" when looking into your retirement accounts. Simply put, vesting means you legally "own" or are entitled to a portion of an account. If you're vested in your employer's pension plan, you're entitled to receive benefits from the plan. If you leave your employer, you can receive some form of payment if you're vested.

  • Employee contributions: You're always 100% vested in any contributions that come from your pay. You can't necessarily withdraw that money whenever you want, but you have a right to take back any funds you contributed.
  • Employer contributions: Vesting on employer-contributed funds often depends on how long you work for the organization. In most cases, you need to meet a minimum service requirement to become fully vested in employer funds — you might be fully vested after five years, or it might take 10 years. It's possible to be partially vested, especially if you only spend a few years working for an organization. Each plan is unique, so check with your employer.

Even if you're fully vested, you usually can't withdraw a pension before retirement. You typically need to stop working for your employer before you can withdraw from your pension. If you have a pension from a former employer, you might be able to withdraw the lump sum in the account, but rules vary from plan to plan. You might have to wait until you reach a certain age before you can start taking benefits.

How Do Pensions Compare With Other Retirement Plans?

A defined benefit pension plan isn't the only retirement plan. Depending on where you work, there might be other options available, such as a 401(k) or an individual retirement account (IRA). How do pensions work compared with other popular options?

  • Contributions: With pension plans, employers make significant contributions to the plan on your behalf. With a 401(k) or 403(b) plan, your employer might contribute, but you're primarily responsible for building the assets in those plans.
  • Investments: With a pension plan, an employer attempts to invest so that the plan can pay benefits to every pensioner from one large pool of money. You generally don't have a separate account to manage. With other retirement plans, you often chart your own investment course.
  • Risk: With a pension plan, an employer takes on significant risk. It promises to pay you a set amount each month or year, and it must meet that promise, regardless of how its investments are performing or how long its pensioners live. By contrast, there is no guaranteed monthly income from a standard 401(k) plan or another self-directed retirement plan. Your retirement income depends on how your investments perform and how much money you contribute over the years.

The Bottom Line

A pension is an employee benefit that promises lifetime income in retirement. To qualify for income and receive a meaningful amount, you generally need to work for the same employer for a set number of years. Your employer's human resources department can tell you how your plan works, and you can ask them how you can maximize your pension income. Delaying retirement by one or two years can often improve your retirement income, so make sure to plan ahead to ensure financial security.

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