After World War II, pensions were an incredibly popular way to save for retirement. While the majority of public sector jobs still have pension plans, in the private sector, they are rapidly disappearing. Now people are more familiar with IRAs and 401(k)s, which have become more popular. But plenty of people still have pension plans, so it’s important to understand how they work, how they differ from other retirement savings vehicles, and their unique benefits and risks.
If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.
What are Pensions?
A pension plan is a retirement plan funded largely by an employer. When people use the term “pension,” they are usually referring to a defined-benefit plan. This means that the amount an employee receives after retiring (the benefit) is specified ahead of time. The amount received is usually calculated based on the number of years the employee was with the company and how much the employee earned while working.
The proceeds from a pension come from the employer, who contributes to a pool of money on behalf of the employee. Depending on the plan, employees may have the ability to make contributions in addition to those made by the employer. This pool of money is invested, and once employees retire, they receive income off of the investment. One of the biggest advantages of a pension is that as an employee you are guaranteed a specific amount, regardless of the performance of the invested funds.
Pension vs Defined-Contribution Plans
A pension is a defined-benefit plan, while other employee-sponsored retirement savings vehicles, such as 401(k)s and 403(b)s, are defined-contribution plans. With a defined-contribution plan, the employer contributes a certain amount. The amount the employee receives upon retiring will depend upon the performance of the fund.
One of the advantages of a defined-contribution plan is that employees have more control over their funds, including decisions about investments, the amount invested, and the amount received. With a pension plan, the employer is in charge of all of these decisions.
Vesting is part of the defined-benefit plan process and is one of the defining differences between pension plans and defined-contribution plans. Vesting is about how and when you become eligible for pension proceeds. It’s possible to become vested immediately upon beginning employment, but vesting can also be a process that takes up to seven years. The vesting timeline is important to understand since it can affect whether you receive a full pension, partial pension, or even no pension. There are two types of vesting, which are cliff vesting and graded vesting. Take a look at their differences below:
When a company uses cliff vesting, if employees leave before they are fully vested, they lose all access to their pension plan proceeds. Typically, the vesting period (the time before the employee is fully vested) is five to seven years. If the employee leaves after the full vesting period has passed, then the employee will receive a full pension, based on how long the employee worked for the employer.
With graded vesting, the vesting process is more gradual. If an employer has a graded-vesting plan, after three years the employee is eligible for 20% of the pension. For every additional year, the employee earns another 20%, until reaching 100%.
Lump Sum vs Annuity
Another major difference between a pension and other retirement savings vehicles is that when you have a pension, you’ll have to choose how you want to receive the proceeds from your pension. It’s important to consider your choice carefully, since your decision is final once you make it. If you choose to receive your pension plan proceeds as an annuity, you’ll receive periodic payments, usually monthly. An annuity provides you with fixed income for the rest of your life (and if your spouse outlives you, he or she may be eligible for some income as well, depending on the plan).
You can also choose to take your pension plan proceeds as a lump sum payment upon your retirement. This option means you don’t have to worry about the company going out of business or being unable to pay your pension later on. You can then invest the lump sum as you see fit. Upon your death, any money that’s left can be passed on to your heirs. However, the major concern with a lump sum payment is that it’s your responsibility to make the money last. There are a lot of factors that go into considering which option is better for you, and it’s important to consider all of them, since your choice will have a major impact on your financial future.
Benefits and Risks of Pensions
There are plenty of benefits associated with pensions, the biggest of which is a source of fixed-income in retirement. But there are also some areas of concern to consider. With a pension, you have no control over how the money is invested. The employer also has the ability to change the rules for the fund as it sees fit. Though this is unlikely, it is not unheard of. Of course, the biggest risk of a pension plan is that if the company closes, the pension is gone.
Seek Advice from an Experienced Financial Advisor
We hope you better understand what pension plans are and how they work. The key to creating a smart retirement plan is to prepare for as many potential outcomes as possible. If you have a pension plan and need help creating a plan for retirement, consider working with a professional financial advisor from Good Life Financial Advisors of Mount Pleasant!