A pension plan is a type of retirement plan where employers promise to pay a defined benefit to employees for life after they retire. This is different from a defined contribution plan, like a 401(k), where employees put their own money in an employer-sponsored investment program. Pensions grew in popularity during World War II and became mainstays in benefit packages for government and unionized workers. While they remain common in the public sector, they’ve largely been supplanted by defined contribution plans in the private sector.
What is a pension plan?
In an ideal world, an employer who offers a pension plan sets aside money for each employee and that money grows over time. The proceeds then cover the income the company promised to pay the employee in retirement. Often, the employee has the choice of taking either a lump sum upon retirement (or when leaving the company) or regular payments for life through an annuity. Depending on the plan, those pension benefits may be inheritable by a surviving spouse or children.
Your pension income is usually paid out as a percentage of your salary during your working years. That percentage depends on the terms set by your employer and your time with the employer. A worker with decades of tenure with a company or government may get 85% of their salary in retirement. One with less time under their belt, or at a less generous employer, may only receive 50%.
Employees with pensions don’t participate in the management of those funds. This is considered a plus, since most people aren’t financial experts. On the flip side, however, the lack of control means employees are powerless to ensure that their pension funds have adequate financing. They must also trust their company to continue operating during their lifetime (…if the company were to go bankrupt, the pension would terminate and payments from the Pension Benefit Guaranty Corporation will kick in.)
If you leave your employer before your pension benefits vest, you forfeit the money your company put aside for your retirement. Vesting schedules come in two forms: cliff and graded. With cliff vesting, you have no claim to any company contributions until a certain period of time has passed. With graded vesting, a certain percentage of your benefits vest each year, until you reach 100% vesting.
Public vs. private pensions
The main difference between a public pension and a private pension is the employer. Public pensions are available from federal, state and local government bodies. Many police officers and firefighters have pensions, for instance. So do school teachers.
Some private companies still offer pensions, but more often than not, they are long running companies that started offering pensions last century. Many companies, however, have frozen their pensions so that new employees are not eligible to receive them.
Compared to public pension funds, private pensions have more legal protections. By law, private companies must make sure their pension funds have adequate funding. Also, they must insure their pensions by paying premiums to the Pension Benefit Guaranty Corporation. Public pensions aren’t subject to the same requirements. Because of this lack of legal protection, many state pension funds are seriously underfunded, which could result in a drastic reduction of benefits if nothing changes.
Pensions and Social Security
People who have pensions from a government employer may not be eligible to receive Social Security benefits, or they may receive only partial benefits. This is because some public-sector workers who have pensions to look forward to aren’t subject to Social Security payroll taxes. Because they don’t pay into the fund, they don’t receive full benefits.
If you worked part of your career in the private sector, but also spent time working a public-sector job with a pension, you may want to prepare for the Social Security Windfall Elimination Provision (WEP). The WEP limits Social Security retirement benefits for people who are also expecting pension income. There is also the Government Pension Offset (GPO), which limits the spousal or survivor benefits available to people who have government pension income.
If you had a government job with a good salary, you likely will have other benefits to count on. For this reason, Congress limited some Social Security benefits, on the assumption that your government pension was already providing you with sufficient retirement income.
Pension plan risks
Although having access to a pension has many benefits, no retirement plan is without risks. Unlike a 401(k) plan or IRA, you have no say in how your company invests the money in your pension fund. If the manager of the fund makes bad investment decisions, that could potentially result in insufficient funds for the overall pension. This would presumably lead to a reduction of your benefits without warning.
Another risk of not being in control is that your company could change the terms of your pension plan. In particular, it could decrease the percentage of salary for each recipient, which will result in a lowered benefit amount. Seeing as pensions are much more expensive for employers than most alternatives, it is in your employer’s interest to minimize costs. In the case of public pensions, there’s also the risk that the state or municipality will encounter economic issues and declare bankruptcy, which could result in a reduction of benefits for pension plan participants.
For these reasons, the partners at S&K advise you to save on your own as a supplement to your pension. You don’t want to count on having a comfortable pension and then be unexpectedly short on funds!
Questions? S&K can help!
If you have questions about pensions, 401(k)s or investing for your future retirement – S&K can help! From income tax planning to financial services and accounting software, Stitely and Karstetter is focused on your future and can help both individuals and corporations achieve their financial goals. If you are seeking a CPA firm that can provide the advanced tax, accounting and investment advice that you need to succeed, contact us today to learn more.