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In 2019, nearly half of families headed by someone 55 or older had no retirement funds. Perhaps you are in this boat, or maybe you are just looking to increase your existing nest egg.
Either way, you may have heard of a pension plan and might be wondering what it is and how it works.
A pension plan is an amount of money, primarily funded by an organization, saved for the employee’s retirement. Although employees often have the option to contribute towards their pension, the primary responsibility of financing and managing the plan falls to the employer.
The rest of this article will provide you with additional details about pensions. More specifically, I’ll tell you how pensions help fund your retirement and how they differ from 401(k) plans.
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How Do Pensions Work?
If you have the option to participate in a pension plan, you may want to know how it will work.
Employers that offer pension plans contribute money into an overall fund for their employees. If you participate in one, you will receive a monthly payment from the fund upon retirement.
The dollar amount you receive will depend on your income leading up to retirement and the company’s formula for determining how much money they contribute to the fund.
Pension plans are usually divided into defined benefit plans, defined contribution plans, and hybrid plans.
Defined Benefit Plans
Defined benefit plans have a predetermined compensation amount for all plan participants. A formula determines the payment for each person. Age, tenure, and salary leading up to and at retirement are all components that the formula takes into consideration.
Upon retirement, you receive your monthly payment regardless of how the well the fund performs overall. The plan’s investment risk lies with the fund manager or your employer.
Someone will be on the hook for paying your guaranteed monthly allotment regardless of the fund’s success.
Defined Contribution Plans
Defined contribution plans are similar to defined benefit funds in that the employer contributes funds to individual employee accounts on the employee’s behalf. When an employee retires, they get monthly checks deposited into their account.
Although that sounds pretty similar, there is one significant difference - the amount received is not defined in advance.
Rather than defining the employee’s benefits on the backend, the employer defines their upfront contribution to the plan. Employee checks post-retirement are a function of the retiree’s age, tenure, total contribution, and how well the account performed leading up to the point of retirement.
A hybrid plan combines different elements from both defined benefit and defined contribution plans. If your employer’s pension stipulates the benefits upon retirement and requires employee contributions, it would be considered a hybrid plan.
Another hybrid example is a cash balance plan. In this plan, future benefits are derived based on the overall fund, and a unique account balance from the general fund exists for each plan participant.
401(k) vs. Pension Plan: What's The Difference?
If your employer offers both a pension and a 401(k) plan, you may be wondering how they differ from one another.
Although employers sponsor pension plans and 401(k) plans, 401(k)s are always defined contribution plans, while a pension plan could also be a defined benefit plan. The employer makes investment decisions for pension plans, but control resides with the employee when it comes to their 401(k).
The most notable differences between the two overall types of retirement plans are:
- The employment length required.
- The ability to move your funds between plans.
- The overall potential for future growth.
Years of Employment
Pensions typically require an employee to have multiple years of service before the employer sets aside any funds on their behalf (usually at least five to seven years of employment for the business).
On the other hand, most 401(k) plans allow employees to contribute funds from their paychecks on their first day of employment. If the employer matches any portion of the contributions, they may not do so immediately.
Companies often begin to match contributions at one year or more of employment, and the percentage match may increase over time.
Pensions are typically not transferable. If you leave your employer after only a few years of service, you may lose the account entirely. If all or some portion of the pension remains available to you after leaving the company, you will need to contact your former employer upon retirement and apply to receive benefits.
401(k) plans are highly portable. If you move to a new company, you can roll over your existing balance to your new employer’s plan to manage all of your retirement funds in one place.
However, before deciding to change jobs, make sure to investigate your current employer’s vesting schedule. This is because employers frequently require that you stay employed for a certain number of years to retain the total amount they have contributed to on your behalf.
Because the employer manages pensions, you have limited say in investment decisions. 401(k) plans allow the employee to determine how aggressive they want to be.
You can also choose where to invest your money, including in mutual funds, index funds, target-date funds, and so on.
While pension plans offering a set amount are arguably the “safer bet,” that predefined amount may well be less than you need during retirement.
If available and feasible, plan to augment your pension with a 401(k). Having a known benefit and a plan with solid upside potential is a great way to diversify.
A pension plan is created on your behalf by your employer, and you have limited control over how it’s invested. 401(k)s offer you more control but are the riskier option.
When possible, it’s always best to ensure that you have both a pension plan and a 401(k).
That said, regardless of whether you save via a pension plan or a 401(k), ensure you plan for retirement. Additionally, when contributing to a plan, contribute at least enough to benefit from the company match.
This will ensure that you’ll have robust savings for your retirement.
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