A pension is a retirement plan provided by companies that offer a monthly payment once you enter retirement. The employer bears all risk and responsibility for funding this plan. If you have a pension the employer guarantees you an income when you hit retirement. Not all employers offer pensions but most government organizations do.
How a Pension Works
There is a specific formula that determines how much a person will receive in pension income when they retire.
The formula uses is based on a combination of the following:
- Years of service
For example, a pension plan may offer a monthly retirement payment that replaces 50% of your compensation based on your last 3 years of service. But, in order to qualify for this plan you need to retire at a certain age, somewhere after 55, and have worked for this company for at least 10 years.
In the same plan above they may have clauses in the pension plan definition. For example, if you retire at 55 you only get 50% of your compensation covered but if you retire at 65 you might get 85% of your compensation covered. The more years you put into a company the more you usually get when they dish out your pension.
All pension plans must follow specific rules set by the Department of Labor. These rules specify how much a company must put away each year to provide everyone with a defined pension in the future.
Pension benefits may be subject to a vesting schedule. A vesting schedule is an incentive program that determines how much you would get depending on how long you’ve been with the company. For example, if you’ve worked at the company for 10 years they can plan ahead for how much you would be eligible to receive in a pension payment per month. This helps companies know how much they need to save and fund the retirement pension they provide.
Are Pensions Taxed?
Yes, all pensions are taxable. There are only a few instances where your pension will not be taxed and those are if you’ve contributed after-tax money, meaning you’ve already paid taxes on it, or if you’re suffering from a disability and your pension comes from the military or another government organization.
You should expect to pay your standard tax amount and have it withheld from each pension payment you receive. In many cases, the first 25% of your pension payments are tax free but the remaining 75% is taxable by the government.
How Pension Plans End
An employer can end a pension plan through a process called “plan termination”. There are two ways an employer can terminate their pension plan: standard termination and distress termination.
A standard termination is when the employer ends the pension plan and has proof they have enough money to pay all benefits owed to the remaining participants. A plan that ends with a standard termination must either pay out lump sums to each person or purchase an annuity for each individual.
A distress termination is when the employer ends the pension plan and does not have the plan fully funded. This can only be applied for if the employer cannot financially support the pension plan and operations, they must be in financial distress. The employer must file for bankruptcy and prove that they cannot remain in business unless the plan is terminated.
If the employer terminates a pension plan then the funds will be frozen. This means that you won’t get any more money aside from what is currently funded to pay you. You won’t accumulate any more pension income. The Pension Benefit Guaranty Corporation (PBGC) may step in and help pay your pension if the company filed for a distress termination.
Alternatives to Pensions
As time went on companies started removing pension plans from their benefits packages. These pension plans were replaced with what most know now as 401(k) plans. These plans offer a variety of investment choices but they don’t offer a guaranteed income like a pension plan did. If your company offers a 401(k) plan and offers a match you should be taking advantage of this before any other retirement planning or investing.
There are some rules that allow employers to offer a qualified longevity annuity contract (QLAC) within a 401(k) plan. A QLAC can provide you with guaranteed income in retirement and if your company offers it you can invest in it to create a guaranteed income source during retirement.
Another alternative to a pension plan is an IRA, or Individual Retirement Arrangements. An IRA is essentially a savings account with tax advantages and you choose how to invest the funds in your IRA. You can also contribute to an IRA even if you have a pension, or 401(k), but your deductions may be limited.
What If Your Company Doesn’t Offer Pension?
If your company doesn’t offer a pension there are ways you can save for retirement and steps to take to make sure you have an income when you retire.
- Identify if your company has a 401(k) plan and contribute if they have one.
- Start an IRA and contribute the maximum amount each year.
- Take time to understand other investment avenues, like stocks or mutual funds.