What is a Pension Plan?
A pension plan is a retirement plan that functions very similarly to the 401k plan. Unlike the 401k, your investment options with a pension plan are somewhat limited, but you will have a certain amount of income when you retire.
The amount you earn with a pension plan depends on the company you work for. They usually take into account the length of time you’ve worked for the company, your salary, among other things.
It’s often said today that pension plans are dead, but that’s not quite true. While pension plans aren’t as common today as they used to be, due to the job market and the prevalence of other retirement plans, some companies still offer them.
The pension plans of today are a little different from how they used to be, but they can still make sense in certain circumstances. Let’s examine what how pension plans work and who they might be good for.
Types of Pension Plans
There are two main types of pension plans. The defined contribution plan, and the defined benefit plan.
Defined contribution plans work a lot like the 401k and similar plans. Under this plan, you make tax-deferred contributions to an account which is then invested until you take distributions during retirement.
Your employer may also contribute to your plan either with monetary contributions or in the form of company stock. The amount you receive at retirement is not guaranteed, rather, it is determined by your contributions and how well the investments performed.
The second type, defined benefit plans, are more rare. This is the classic pension plan that was common back in the day, and is what most people think of when they hear “pension plan”.
With a defined benefit plan your employer makes all the contributions to the plan and you are guaranteed a certain amount at retirement.
You don’t have to do anything. Enrolling, making contributions, and choosing investments is all taken care of for you. Even if the investments perform badly, your plan is at least somewhat protected by the PBGC and will guarantee some of your benefits.
Defined benefit pensions are rare, and the company gets to decide who is eligible for them. If you are offered one, it could be a great opportunity for you. But, keep in mind that if you leave the company before retirement you are not allowed to take your pension with you.
Are They Good?
Pension plans can be good in certain circumstances, especially defined benefit plans. The terms will vary by company, and it’s important to know exactly what you’re getting into beforehand.
If you’re serious about a pension plan, make sure to talk with your company’s HR representative and get the exact details about your company’s plan. Even if you might like a pension in general, your company’s specific plan might not be what you’re looking for.
Pension plans give you two options for taking distributions when it comes time to retire. They are monthly, where you will receive payments for the rest of your life, or lump sums, where you are given the entire amount in full.
With a monthly payment, you will be paid at a fixed rate, and typically without inflation protection. If you don’t have inflation protection, the real value of your payouts could become lower over time as inflation stacks up.
Taking a lump sum payment has certain advantages. For instance, you avoid the risk of losing your funds if your company goes broke. The PBGC would only cover some of the lost funds, but by taking a lump sum you avoid the problem completely.
Additionally, you can take your lump sum and reinvest it into other assets to keep it generating income for you.
Taking a lump sum payment could also make sense if you need to pay off high interest debts. The savings from not having to pay interest on the debt could make the lump sum payment worthwhile.
If you’re old or in bad health taking a lump sum will make the most sense. On the other hand, if you take monthly payouts and outlive your projected age you will come out ahead.
There are downsides to lump sum payments too. You will need to have enough discipline to make your funds last for the rest of your life. Also, taking a lump sum might push you into a higher tax bracket. If you’re already in a high tax bracket then taking a lump sum will wipe out a large chunk of it.
You’ll have to do some calculations on your own to figure out whether monthly or a lump sum distribution would be more beneficial in your specific situation.
Should I Choose a Pension Plan?
So, should you choose a pension plan? It depends. Pension plans can be good or bad depending on your specific situation.
They can be a good choice for people who are totally sure they’re going to be working for the same employer until retirement. These are usually people who work for the government or work for a company that has a large union.
However, pension plans are a bad choice for those who are going to be changing jobs over the course of their career. This is especially dangerous for young people because they have their entire career ahead of them and don’t know what the future holds.
The investment options for pension plans are very limited, even more limited than common plans such as the 401k. What this means is that you won’t be able invest in high performing assets or be able to diversify as much in order to protect your assets during economic uncertainty.
Also, pensions aren’t good for protecting against inflation. Inflation already eats away at people’s retirement savings, and it’s expected to increase even more in the future. With the economic uncertainty in America right now, who knows what the future could hold.