What Is a Pension? Types of Plans and Taxation

What Is a Pension Plan?

A pension plan is an employee benefit that commits the employer to making regular contributions to a pool of money set aside to fund payments to eligible employees after they retire.

In the United States, traditional pension plans, known as defined-benefit plans, have become increasingly rare and are being replaced by defined-contribution plans that are less costly to employers, such as the 401(k) retirement savings plan.

Understanding Pension Plans

A pension plan requires contributions by the employer and may allow additional contributions by the employee. The employee contributions are deducted from wages. The employer may also match a portion of the worker’s annual contributions up to a specific percentage or dollar amount.

A pension plan is more complex and costly to establish and maintain than other retirement plans. Depending on the plan type, employees may have no control over the investment decisions concerning the funds. In addition, an excise tax applies if the minimum contribution requirement is not satisfied or if excess contributions are made to the plan.

Types

There are two main types of pension plans: the defined-benefit plan and the defined-contribution plan.

The Defined-Benefit Pension Plan

With a defined-benefit pension plan, the employer guarantees that the employee will receive a specific monthly payment after retiring and for life, regardless of the performance of the underlying investment pool. The employer is thus liable for pension payments to the retiree in a dollar amount typically determined by a formula based on earnings and years of service.

If the assets in the pension plan account cannot pay all of the benefits, the company is liable for the remainder. Defined-benefit employer-sponsored pension plans date from the 1870s. The American Express Company established the first pension plan in 1875. At their height in the 1980s, they covered 38% of all private-sector workers.

The Defined-Contribution Pension Plan

With a defined contribution pension plan, the employee makes contributions, which may be matched to some degree by the employer. The final benefit to the employee depends on the investment performance of the plan.The company’s liability ends when the total contributions are expended.

The 401(k) plan is a defined-contribution pension plan, although the term "pension plan" is commonly used to refer to the traditional defined-benefit plan. The defined-contribution plan is less expensive for a company to sponsor, and the long-term costs are easier to estimate. It also takes the company off the hook for future additional costs beyond agreed-to contributions.

For this reason, a growing number of private companies are moving to the defined-contribution plan. The best-known defined-contribution plan is the 401(k), and its equivalent for non-profit employees, the 403(b).

Variations

Some companies offer both types of pension plans. They even allow participants to roll over 401(k) balances into defined-benefit pension plans.

There is another variation, the pay-as-you-go pension plan. Set up by the employer, these may be wholly funded by the employee, who can opt for salary deductions or lump-sum contributions, which are generally not permitted for 401(k) plans. They are similar to 401(k) plans but rarely offer a company match. 

A pay-as-you-go pension plan is different from a pay-as-you-go funding formula. Current workers’ contributions are used to fund current beneficiaries. Social Security is an example of a pay-as-you-go program.

Pension Plans: Factoring in ERISA

The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law designed to protect retirement assets. The law establishes guidelines that retirement plan fiduciaries must follow to protect the assets of private-sector employees.

Companies that provide retirement plans are referred to as plan sponsors (fiduciaries), and ERISA requires each company to provide a specific level of information to eligible employees. Plan sponsors provide details on investment options and worker contributions matched by the company.

Employees must understand vesting, the amount of time required to begin to accumulate and earn the right to pension assets. Vesting is based on the number of years of service and other factors.

Pension Plans: Vesting

Enrollment in a defined-benefit plan is usually automatic within one year of employment, although vesting can be immediate or spread out over as many as seven years. Leaving a company before retirement may result in losing some or all pension benefits.

With defined-contribution plans, an individual's contributions are 100% vested as soon as they are paid in. If your employer matches those contributions or gives you company stock as part of a benefits package, it may set up a schedule under which a certain percentage is handed over to you each year until you are fully vested.

Just because retirement contributions are fully vested doesn’t mean that you’re allowed to make withdrawals, however.

Pension Plan Taxation

Most employer-sponsored pension plans are qualified, meaning they meet Internal Revenue Code 401(a) and ERISA requirements. That gives them their tax-advantaged status for both employers and employees.

Contributions that employees make to the plan come "off the top" of their paychecks—that is, are taken out of the employee's gross income. That effectively reduces the employee's taxable income, and the amount they owe to the IRS come tax day. Funds placed in a retirement account then grow at a tax-deferred rate, meaning no tax is due on the funds as long as they remain in the account.

Both types of pension plans allow the worker to defer tax on the retirement plan’s earnings until withdrawals begin. This tax treatment allows the employee to reinvest the full complement of dividend income, interest income, and capital gains, all of which compound and can generate a much higher rate of return over the years before retirement compared to if they were taxed.

Upon retirement, when the account holder starts withdrawing funds from a qualified pension plan, federal income taxes are due. Some states will tax the money, too.

If you contributed money in after-tax dollars, your pension or annuity withdrawals will be only partially taxable. Partially taxable qualified pensions are taxed under the Simplified Method.

Modified Pension Plans

Some companies are keeping their traditional defined-benefit plans but are freezing the benefits. This means that after a certain point, workers will no longer accrue greater payments, no matter how long they work for the company or how large their salary grows.

When a pension plan provider decides to implement or modify the plan, the covered employees almost always receive credit for any qualifying work performed prior to the change. The extent to which past work is covered varies from plan to plan.

When applied in this way, the plan provider must cover this cost retroactively for each employee in a fair and equal way over the course of his or her remaining service years.

Pension Funds

When a defined-benefit plan is made up of pooled contributions from employers, unions, or other organizations, it is commonly referred to as a pension fund.

Managed by professional fund managers on behalf of a company and its employees, pension funds can control vast amounts of capital and are among the largest institutional investors in many nations. Their investment actions can dominate the stock markets.

Pension funds are typically exempt from the capital gains tax. Earnings on their investment portfolios are tax deferred or tax exempt.

A pension fund provides a fixed, preset benefit for employees upon retirement, helping workers plan their future spending. The employer makes the most contributions and cannot retroactively decrease pension fund benefits.

Voluntary employee contributions may be allowed as well. Since benefits do not depend on asset returns, benefits remain stable in a changing economic climate. Businesses can contribute more money to a pension fund and deduct more from their taxes than with a defined contribution plan.

An employee’s payout depends on the final salary and length of employment with the company. No early withdrawals are available from a pension fund. Pension fund loans are risky and, in some cases, illegal. In-service distributions are not allowed to a participant before age 59 1/2. Taking early retirement generally results in a smaller monthly payout.

Pension Plans vs. 401(k)

A pension plan and 401(k) can both be used to invest money for retirement. However, each vehicle has its strengths and weaknesses.

• While a pension plan is often primarily funded by an employer, a 401(k) is primarily funded by an employee.
• Employees can choose contribution amounts to put into a 401(k) and potentially receive matched funds from employers based on IRS contribution limits.
• A 401(k) is a defined-contribution plan, while a pension may be a defined-benefit plan.
• Under a 401(k) plan, employees often have greater control of their retirement plan. They have some degree of choice regarding what securities to invest their savings in as well as how much to contribute towards retirement. On the other hand, pension plans are more suitable for investors who want a guaranteed fixed income for life.
• A 401(k) is portable. When an employee leaves a company, they can take their 401(k) with them by rolling over the balance into an individual retirement account (IRA). Alternatively, when an employee leaves a company in which they have a vested pension benefit, the employee must keep track of their pension benefit after their departure. Then, when the individual is ready to retire, they must apply for the pension benefits.

Monthly Annuity or Lump-Sum?

With a defined-benefit plan, you usually have two choices when it comes to distribution: periodic (usually monthly) payments for the rest of your life, or a lump-sum distribution.

Some plans allow participants to do both; that is, they can take some of the money in a lump-sum and use the rest to generate periodic payments. In any case, there will likely be a deadline for deciding, and the decision will be final.

There are several things to consider when choosing between a monthly annuity and a lump-sum. 

Annuity

Monthly annuity payments are typically offered as a choice of a single-life annuity for the retiree only for life, or as a joint and survivor annuity for the retiree and spouse. The latter pays a lesser amount each month (typically 10% less), but the payouts continue until the surviving spouse passes away.

Some people decide to take the single-life annuity. When the employee dies, the pension payout stops, but a large tax-free death benefit is paid out to the surviving spouse, which can be invested.

Can your pension fund ever run out of money? Theoretically, yes. But if your pension fund doesn’t have enough money to pay you what it owes you, the Pension Benefit Guaranty Corporation (PBGC) could pay a portion of your monthly annuity, up to a legally defined limit.

For 2024, the monthly maximum PBGC guarantee for a straight-life annuity for a 65-year-old retiree is $7,107.95. The PGBC maximum monthly guarantee for joint and 50% survivor annuity for a 65-year-old retiree is $6,397.16. Of course, PBGC payments may not be as much as you would have received from your original pension plan.

Annuities usually pay at a fixed rate. They may or may not include inflation protection. If they don't, the amount you get is set from retirement on. This can reduce the real value of your payments each year, depending on the rate of inflation at the time.

Lump-Sum

If you take a lump-sum, you avoid the potential (if unlikely) danger of your pension plan going broke. Plus, you can invest the money, keeping it working for you—and possibly earning a better interest rate, too. If there is money left when you die, you can pass it along as part of your estate.

On the downside, there's no guaranteed lifetime income. It’s up to you to make the money last.

And unless you roll the lump-sum into an IRA or other tax-sheltered accounts, the whole amount will be immediately taxed and could push you into a higher tax bracket.

If your defined-benefit plan is with a public-sector employer, your lump-sum distribution may only be equal to your contributions. With a private-sector employer, the lump-sum is usually the present value of the annuity (or more precisely, the total of your expected lifetime annuity payments discounted to today's dollars).

Of course, you can always use a lump-sum distribution to purchase an immediate annuity on your own, which could provide a monthly income stream, including inflation protection. As an individual purchaser, however, your income stream will probably not be as large as it would with an annuity from your original defined-benefit pension fund.

Which Yields More: Lump-Sum or Annuity?

With just a few assumptions and a small math exercise, you can determine which choice yields the largest cash payout.

You know the present value of a lump-sum payment. To figure out which makes better financial sense, you need to estimate the present value of annuity payments. To determine the discount or future expected interest rate for the annuity payments, think about how you might invest the lump-sum payment and then use that interest rate to discount back the annuity payments.

A reasonable approach to selecting the discount rate would be to assume that the lump-sum recipient invests the payout in a diversified investment portfolio of 60% stocks and 40% bonds. Using historical averages of 9% for stocks and 5% for bonds, the discount rate would be 7.40%.

Imagine that Sarah was offered $80,000 today or $10,000 per year for the next 10 years. On the surface, the choice appears clear: $80,000 versus $100,000 ($10,000 x 10 years). Take the annuity.

However, the choice is impacted by Sarah's expected return (or discount rate) on the $80,000 over the next 10 years. Using the discount rate of 7.40% noted above, the annuity payments are worth $68,955.33 when discounted back to the present, whereas the lump-sum payment today is $80,000. Since $80,000 is greater than $68,955.33, Sarah would take the lump-sum payment.

This simplified example does not factor in adjustments for inflation or taxes, and historical averages do not guarantee future returns.

Other Deciding Factors

There are other basic factors that must almost always be taken into consideration in any pension maximization analysis. These variables include:

• Your age
• Your current health and projected longevity
• Your current financial situation
• The projected return for a lump-sum investment
• Your risk tolerance
• Inflation protection
• Estate planning considerations

The Bottom Line

A pension plan offers employees the opportunity to earn defined benefits at retirement. Different companies can have different features within their pension plan, but employers often fund a majority of defined-benefit pension plans while guaranteeing employees specific retirement benefits based on their tenure and salary.

As opposed to a defined-contribution plan such as a 401(k), a defined-benefit pension plan offers an employee a fixed payment for life once they retire.