What Is a Pension?

Retirement & Investing
on April 10, 2012

A pension is a retirement plan funded by an employer. It's classified as a defined benefit plan because the payout at retirement is predetermined regardless of individual contribution and regardless of how well the investments involved in the pension plan perform. Most private employers have gone away from defined benefit plans, such as pensions, in favor of less financially restrictive defined contribution plans, such as 401(k)s. Most public employees, including teachers, firefighters and policemen, still receive a pension upon retirement.

What does a pension pay? The experts at CNNMoney report that a pension payout is dependent on how long you worked for the employer and what your salary was. Most government agencies that offer a pension as part of a retirement package give a certain percentage of your highest salary multiplied by each year worked for them up to a certain predetermined amount. For example, an employer might offer 2.5 percent of your highest salary for each year you worked for the company, up to 75 percent of your salary.

What is vesting? When an individual becomes vested, he or she qualifies to receive pension benefits. Two different vesting options exist:

  • Cliff vesting — If you work for the company for a specific amount of time, you are entitled to receive full benefits at retirement age. If you quit the job before becoming vested, you lose all benefits.
  • Graded vesting — With graded vesting, the employee gains a certain percentage each year he or she works for the company. Most employers have a minimum year requirement to become partially vested.

When are pension benefits paid out? This, too, depends on the company or government entity paying the pension. Most begin payments at retirement age, currently 65 to 67, depending on the year you were born. Some employers and government entities allow you to receive a pension before retirement age if you've worked for them for 30 years or more.

What are the plusses and minuses of a pension plan? Because pensions provide a predetermined benefit, it's easier for retirees to calculate when to retire. In addition, it's a lifelong benefit, so it removes the worry of outliving one's finances. The downside to a pension is the pension recipient has no control over the investments and will lose many of the benefits if he or she does not remain with the company long term. In addition, when private companies go bankrupt, with bankruptcies often caused by having to fund past pension plans, pension benefits are eliminated.

If your company offers a pension plan, take advantage of it. It would be wise, however, to take control of your retirement savings using other methods as well.

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