A pension is a retirement plan sponsored by your employer. There are two types of pensions: defined contribution and defined benefit. Defined contribution pensions deduct a portion of each paycheck and include plans such as 401(k)s and 403(b)s [link to 2.5.2]. Defined benefit pensions are funded by your employer and, at retirement, are guaranteed income for a defined period of time or even your lifetime.
Defined benefit plans are much less common today than they have been in the past. Due to recent economic conditions, most corporations have eliminated or reduced their defined benefit plans, replacing them with defined contribution plans, such as 401(k)s and 403(b)s, where the employee contributes a portion of his or her salary.
How does a pension work?
In a defined contribution plan, the employee, employer or both make contributions to the employee’s individual account, and those contributions are then invested. The value of the account will change based on contributions made and fluctuations in the value of the investments.
In a defined benefit plan, the money contributed to you individual account doesn’t come out of your salary; it comes from your employer. Defined benefit plans are much less common today than they have been in the past. Due to recent economic conditions most corporations have eliminated or reduced their defined benefit plans because of their cost, replacing them with defined contribution plans.
Some organizations offer both types of pensions. In this case, many employees opt into both, oftentimes because the defined benefit program offers only a portion of their retirement income needs.
Benefits and risks of pensions
If your defined contribution plan includes contributions from your employer, you benefit by having additional savings added into your fund that don’t come out of your paycheck. However, regardless of what amount is put into your account by you, your employer, or both, the value of your account is not guaranteed. Since the contributions paid into a defined contribution plan are placed in investments, the value of your account can rise and fall with the value of the investments.
Defined benefit plans are comparatively low-risk: you’re not responsible for paying into the fund and your payout is guaranteed. However, these plans are simply being offered by fewer and fewer companies. And, as with Social Security, you’ll likely want to have other forms of income as well.
Depending on what kind of pension you have, your payout may or may not be significantly affected by your employment duration. Defined contribution plans are portable; defined benefit plans are not. Defined benefit plans rely on your employer’s contributions and eligibility requirements while defined contribution plans are funded primarily by the employee and are subject to the plan’s vesting schedule. Be sure to learn what provisions your employer’s plan has in place.
Know the distinction between defined benefit and defined contribution pensions. If you’re going to participate in a 401(k), make sure you understand your responsibility to invest. If you’re fortunate to have one of the few remaining defined benefit pension plans, know what the eligibility requirements are and don’t overlook planning on some other sources to supplement your retirement income.