Published
3 Min. Read

What Is a Pension?

3 Min. Read
Older man asking what is a pension

A pension is a specific monthly payment an employer pays to former employees during their retirement. This amount typically depends on your compensation and the number of years you worked for a company. A pension plan can be funded by an employer, employee, or both. Generally, though, a traditional pension plan is funded by contributions from the employer. 

Who Is Eligible for a Pension? 

Pensions are more common among labor unions and public service employees. If a place of employment does offer a pension, there is usually a vestment period the employee must meet before becoming eligible for a pension. To begin collecting on a pension, the employee must have worked at the company for a certain number of years and meet an age requirement.

What Are the Different Types of Pension Plans? 

Defined-benefit plans and defined-contribution plans are the two most common types of pensions. Both plans are paid out during the employee’s retirement, but the terms for each differ. 

Defined-Benefit Plans 

In a defined-benefit plan, the amount paid is determined by considering the number of years an employee worked for the company, the employee’s salary, and a multiplier decided by the employer. This is a guaranteed amount that employees can count on to receive in retirement. However, corporate profits could impact the employer’s contributions to the pension. 

Defined-Contribution Plans 

Defined-contribution plans don’t provide employees with a guaranteed amount. Instead, the employee contributes money to the plan out of their salary. A company may decide to match a percentage of an employee’s contribution but isn’t required to do so. The employee takes responsibility for the management of investments through the plan. A 401(k) is considered a defined-contribution plan, although it is not technically a pension. 

What Is the Difference Between a Pension and a 401(k) Plan? 

A pension is a defined-benefit plan, while a 401(k) is a defined-contribution plan. In a pension, the employer takes on the liability of funding the plan, while in a 401(k), the employee takes ownership of contributing. An employer may match an employee’s contribution to a 401(k).   

A 401(k) allows workers to take responsibility for their retirement savings. An employee contributes a percentage or dollar amount to the plan from pre-tax wages. It is up to the employee to decide how much to contribute and invest. The employee is often responsible for choosing the type of investment and managing the funds accordingly. The funds may increase or decrease depending on the stock market. Taxes on a 401(k) are deferred until retirement. 

How Do Pension Plan Payments Work?  

After you have met the vesting and time requirements for your pension, you will be able to begin receiving payments from your pension plan. Pension payments are considered income and are taxable. However, the amount you are taxed on this income will depend on how the pension funds were initially contributed.

Pension payments may end at an employee’s death. However, many plans provide the option for payments to continue to a surviving spouse or dependent children. The dependents or beneficiaries likely won’t receive the full amount of a pension payment but a portion of the distribution. 

There are two ways pension plan payments can be paid. 

Lump-Sum 

The full balance of the pension can be distributed as a lump sum as soon as the employee has met eligibility requirements. This approach allows individuals to decide whether to spend, save, or invest funds. The potential risk of a lump-sum payment is that it will be spent too quickly.  

Monthly Payment 

A regular monthly payment is another way to receive pension plan distributions. These payments will continue for the duration of an employee’s life, and in some instances, the funds will be available to a surviving spouse after the employee’s death. Having regular monthly payments may curtail overspending and offer peace of mind that payments will continue for a spouse after an employee’s passing.