Pensions have long been a cornerstone of retirement planning, offering a steady stream of income after leaving the workforce. However, the landscape of pensions has evolved significantly over the years, with different types emerging and varying levels of security. According to the U.S Bureau of Labor Statistics, in March of 2023, only 15% of private industry employees had access to a defined benefit plan while 67% had access to a defined contribution plan, typically a 401(k). Although pension plans are continuing to become less common in private companies, there are still many companies that offer them or have legacy plans that they continue to maintain. Additionally, pensions are common in the public sector - for example for teachers, judges, police, and firefighters.
Because pensions offer some certainty in retirement income, many people don’t worry much about their pension or assume their pension will cover the necessary living expenses in retirement. As a result they don’t take the time to educate themselves about how their pension works and the choices available to them. These choices can have a significant impact on their families, and it’s important and valuable for employees with pensions to understand how best to plan. Understanding the different types of pensions, how they work, and how they fit into your overall retirement income is crucial for making informed decisions about your financial future and we explore these below.
Types of Pensions
- Defined Benefit (DB) Pension Plans: These plans guarantee a specific monthly payment (i.e. a defined benefit) upon retirement, often based on factors like salary and years of service. The employer assumes the investment risk, making these plans generally more secure. However, they are becoming less common due to the high costs associated with funding them and the risk to the employer.
- Defined Contribution (DC) Pension Plans: When people think of defined contribution plans, they generally think of the most common type of profit-sharing plan, the 401(k), where the employee and/or the employer contribute to the plan. However there are defined contribution pension plans too. These plans don’t guarantee a specific monthly payment like the DB plan, but are still designed to support employees in retirement. Unlike a 401(k) plan, they require the employer to make contributions, which is one reason they are less popular today. Generally DC pension plans have been supplanted by profit-sharing plans, although there may still be situations where DC pension plans are offered.
- Cash Balance Pension Plans: This is a DB pension plan that shares some features with DC plans. This type of plan reduces the risk to the employer inherent in guaranteeing a retirement benefit to employees. As employers have moved away from traditional DB pension plans, many have converted them to cash balance plans. Those who worked at the company before the transition will often have both a cash balance plan and a profit sharing plan.
How Pensions Work
- Employer Contributions: Typically, especially for DB pension plans, the burden of saving and investing money for a worker’s retirement falls on the employer. Although some DB plans, especially in the public sector, now require employees to contribute money as well.
- Employee Contributions: As companies have shifted to profit-sharing plans, primarily 401(k)s, the lion’s share of contributions come from employees, although often employers match some amount of the employee’s contribution. It’s easy to see how this reduces the responsibility for funding employees’ retirements from employers to employees.
- Investment Growth: The funds in your pension plan are typically invested in a variety of assets, such as stocks, bonds, and cash. The growth of these investments determines the size of your retirement benefit.* For most pension plans the investment choices are controlled by the employer or whoever manages the plan on behalf of the employer. For profit-sharing plans the employee chooses from a variety of options provided by the employer. Cash balance plans often give the employee some choice over their investments.
- Distribution: When you retire, you can choose to receive your pension benefits as a lump sum payment or as a monthly annuity. If you choose the monthly annuity, there can often be 4 or more options in how that will pay out. The biggest distinction is whether that annuity pays until your death or until your spouse’s death if they outlive you.
Making Informed Decisions
- Understand Your Options: Research the different types of pensions available to you and how they work.
- Consider Your Risk Tolerance: Evaluate your comfort level with investment risk when choosing between defined benefit and defined contribution plans.
- Diversify Your Retirement Income: Don't rely solely on pensions for your retirement income. Explore other savings and investment options.
- Consult a Financial Advisor: A professional can help you assess your retirement goals and develop a personalized financial plan.
Pensions, once a cornerstone of retirement security which may still be a significant source of retirement income for some, have become less common in recent years and should also not be relied upon exclusively. As more and more people turn to individual retirement accounts (IRAs) and 401(k)s, it's crucial to understand the importance of financial planning for a comfortable retirement. It's essential to have a diversified retirement plan that includes multiple sources of income, such as Social Security, part-time work, personal savings, and investments.
Financial planning is not just about saving money; it's about ensuring you have the resources to live the life you want. A well-crafted plan is optimized across all the pieces of your financial world, and can help you avoid running out of money by understanding all the moving and unpredictable parts, reduce stress by knowing you have a financial safety net and truly have these years be golden by focusing on the things that matter most to you. This is true whether you have a pension or not.
Would you like to discuss your pension or some other specific aspect of retirement planning? I am happy to help you understand what your future looks like. Please use my calendar link here to schedule some time.
*For traditional DB plans this isn't strictly true because the employer guarantees a benefit. However, and this has happened to a number of big plans over the years, if investment performance hasn't kept up, the plan could collapse. This helps us see why employers have tried to get out from under this risk.
Aha Financial offers fee-based planning, wealth advisory services, and securities through Park Avenue Securities LLC (PAS) and insurance through The Bulfinch Group Insurance Agency, LLC. Fee-based plans may include tax and wealth planning suggestions, but we do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation. Investment Advisor and Registered Representative of PAS and insurance broker of The Guardian Life Insurance Company of America (Guardian), supervised from: 160 Gould Street, Suite 310, Needham, MA 02494, 781-449-4402. PAS is a member of FINRA & SIPC and a wholly-owned subsidiary of Guardian. Aha Financial and The Bulfinch Group are affiliated, but neither are an affiliate or subsidiary of PAS or Guardian. 7076447.1 Exp 10/26