How Do Pension Plans Work?

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One of the most common myths about retirement planning is that a pension and a 401(k) plan are exactly the same. The truth is that a 401(k) plan offers more flexibility than a pension, but a pension can sometimes be a more reliable form of retirement income. Pensions used to be very popular prior to the 1990s, but in recent decades less companies are offering pensions. It is important to know how a pension works if you do find a job with a company that offers this form of retirement planning.

What Is A Pension Plan?

A pension plan is a retirement program offered by a company that is funded partly by the employee, but mostly by the company. Some companies tie their pension plans to their stock prices to encourage employees to be more productive. In other cases, employees get to choose some of the investments that are tied to their pension, but not all. In this way, a pension is much more reliant on guidance from the company than the employee.

How A Pension Pays

Employees who enter the pension plan are given a chart that shows them how much income they would be paid per month based on years of service. The more years of service an employee put in, the higher their monthly pension payment would be. As economic conditions change, the company may decide to update the chart and alter the pension amounts. When an employee retires, their pension starts with the amount on the chart that corresponds to their years of service. Some companies offer small cost of living increases each year to pension payments.

Pension As Part Of An Employment Package

A pension is one part of an employment package meant to lure talented employees to work for the company. To some people, the idea of a pension based on company stock is a very enticing reason to work for that company. To other people, the inflexibility of a pension plan means that their retirement could be at risk if the company stock fails.

Pension Versus 401(k)

With a 401(k), employees have complete say over how their money is invested. Companies contribute to most 401(k) programs, but it is normally an even split between employee and company contributions. A 401(k) plan can be enticing to an employee who wants control over their retirement savings account, which will allow the employee to move their money to other investments if their current investments become unstable.

Pensions came under scrutiny in the early 2000s when several large companies announced that they would be cutting back on how much they are paying in existing pension accounts. Since then, the idea of a pension has not been considered as lucrative as it used to.

Many public companies that trade stock offer pensions based on the company stock to help entice employees to come work for them. A pension, when administered properly, can be a very stable and reliable form of retirement planning.