What are pensions?
Written by True Tamplin, BSc, CEPF®
Updated on June 21, 2021
Pensions are employer-sponsored retirement plans for regular payments to retired employees. Employers fund pensions from company income. A pension is a defined benefit plan, meaning employees are promised a fixed amount of money upon retirement. Pensions are popular incentives to retain employees. Over the years, however, their popularity has waned and fewer private organizations offer pensions to employees.
Basics of Pensions
Employers decide the amount of pension payments for employees based on a couple of different factors:
- Tenure at an organization
- Salary and position
The general rule is that the longer you stay within an organization, the higher your pension. For example, an employee who has worked at an organization for their entire working life will receive more in pension payments than another employee who works for ten years.
Pensions must be disbursed based on the Department of Labor’s rules. The Pension Benefit Guaranty Corporation (PBGC), a federal organization, is tasked with managing pension payments for employers who have insured their pension plans.
Employers fund pension plans by making monthly salary deductions from employee salaries each year. Unlike 401(k)s, where investment decisions are made by employees, the employer is responsible for making investment decisions. Pension funds are responsible for managing this money and their choice of distribution is stocks, bonds, and commercial real estate.
With assets under management running into billions of dollars each year, pension funds are some of the largest money managers in the markets. some examples of the biggest pension funds in the country are:
- California State Teacher Retirement Systems (CalSTRS)
- California Public Employees Retirement Systems (CalPERS)
How do Pension Plans Work?
Pension plans pay out a specific percentage of employee salaries from a set number of final years of their employment before retirement. This figure is then multiplied by the number of years of service. The terms and amount of payment depend on terms specified by the employer.
For example, an employer might choose to pay 2% of an employee’s average salary for the final five years of his or her service. In that case, an employee who has worked for 20 years with an organization and has an average salary of $100,000 for the final five years will receive annual payments of $40,000. Generally, the salary percentage for pension payments varies between 1% to 3%.
Pensions are paid out for a specific number of years, say 10 years or 20 years, before being terminated. Employees can also specify payout beneficiaries who will continue to receive payments after their demise. Depending on employer terms, pensions can be collected as an annuity i.e., regular payments received annually or as a one-time payment.
Pensions Vs. 401(k)s
It is easy to confuse 401(k)s and pension plans because both are retirement plans with similar elements, such as guaranteed income and possible tax benefits.
But there are several differences between them. Some of them are as follows:
- A 401(k) is a defined contribution plan, with matching employer contributions, while pension plans are defined benefit plans.
- A 401(k) offers more investment choices than a pension plan.
- The returns from a 401(k) depend on investment choices made by the employee while pension plans promise a guaranteed income upon retirement.
- Pension plans reduce overall taxable income because they are funded with pre-tax dollars while some 401(k) plans allow after-tax contributions, making retirement withdrawals tax-free for those contributions.
The Dwindling Popularity of Pensions
Numerous statistics over the years have documented the dwindling popularity of pension plans with private sector employers. According to a 2018 National Labor Compensation by the Bureau of Labor Statistics, pensions were available to only 17% of private sector workers. News reports and researchers have also measured the underfunding gap of state retirement systems. At the end of 2020, the PBGC was running an accumulated financial deficit of $48.3 billion. Meanwhile, 401(k)s have become more popular.
Several theories have been put forward to explain why pensions have fallen out of favor. According to a book by investigative journalist Elizabeth Schulz, mismanagement of pension funds is the main reason for the unpopularity of pensions. She writes that companies spent money from pension plans on unnecessary expenses, such as to hike executive pay. The weakening of company unions, who were representatives of worker rights, has also led to lax enforcement of pensions by private firms, some say.
Companies blame the shift towards 401(k)s on the costs and bureaucracy associated with maintaining a pension plan. The returns for 401(k) plans are dependent on employee investment decisions.
In a pension plan, employers take on market risk because they are responsible for making investment decisions. The downside to this is that they have to generate returns even during economic downturns, making it difficult for them to fund their pensions at optimal levels.