What Is a Pension? Everything You Need to Know

Do you know what pensions and movie rental stores have in common? They've both been replaced by the “new way” of doing things. Netflix took down Blockbuster, and the 401(k) put pension plans on the endangered species list.

Today, only 15% of workers in the private sector (not the government) who have access to an employer-sponsored retirement plan are covered by a pension.¹ Union workers and folks working in the public sector (think teachers and police officers) make up the majority of pension-holders.

Whether you still have access to a pension or have a loved one who does, it’s important to understand how pensions work so that you can make the best choice for your and your family’s retirement future. Let’s dive right in.  

What Is a Pension?

A pension plan, also known as a defined benefit plan, is a company-sponsored retirement plan that “guarantees” you a monthly check (or one lump-sum amount) once you retire.

Generally, pension plans are funded solely by your employer based on your salary, age and the number of years you worked. Think of it like a retirement account that your employer funded instead of you.

Pension plans used to be the most popular and widespread employer-sponsored retirement plan in the U.S., but they’ve gradually been replaced by 401(k) plans and other defined contribution plans.

The few companies and industries that still offer pension plans are looking for a way out of their pension obligations because of the rising costs of running a pension. Some employers are giving their employees a choice: Take a lump-sum payment now or hang on to their pension and receive a monthly payment for the rest of their lives when they retire later. We’re going to walk you through both of those options below.

How Does the Lifetime Monthly Payment Work?

If you choose your pension plan’s monthly lifetime payment option, that means you’ll get a benefit check every month for the rest of your life after you retire (kind of like an annuity). Traditionally, this is how pension plans usually work.

The monthly benefit will always be the same amount. So if your monthly lifetime payment is $1,000, then you’ll get $1,000 each month like clockwork. And yes, you do need to pay taxes on your pension payments.

In most cases, pension plans will use a formula to calculate how much your monthly payment will be. That formula usually looks at three things:

1. Years of service. If you worked at the company for 25 years, that’s the number that’ll be used in the formula. Pretty straightforward! The longer you’ve worked at your company, the larger your monthly benefit will be.
2. Your final average salary. Depending on what state you’re in, this number might look a little different. But in most cases, companies will use your final three to five years of salary in the formula. Some places will take the average of three to five years of your highest salary years and use that number instead. It just depends!
3. A benefit multiplier. This is just a percentage (usually between 1–2%) that pension plans use to figure out the size of your benefit.

So, what’s the actual formula? Here it is:

(Years of Service) x (Your Final Average Salary) x (Benefit Multiplier)

= Annual Lifetime Benefit

Let’s go through an example so you can see how this plays out in real life. Meet Mr. Simmons. He’s a teacher who just turned 65 and he’s worked at the same school for 30 years. Now he’s ready to call it quits and move to Florida like he’s always dreamed about. Sounds nice!

Market chaos, inflation, your future—work with a pro to navigate this stuff.

He’s planning on taking the monthly lifetime benefit, but now he’s wondering how much money he’ll receive from his pension each month. Mr. Simmons’ average final salary over the last three years was $50,000 and the pension plan uses a 2% benefit multiplier to figure out what someone’s annual lifetime benefit will be. So now all he has to do is plug in the numbers:

Step 1: (30 years of service) x ($50,000 final average salary) = $1,500,000

Step 2: $1,500,000 x (2% benefit multiplier) = $30,000 lifetime annual benefit

Step 3: $30,000 lifetime annual benefit / 12 months = $2,500 monthly benefit

That means Mr. Simmons will get $30,000 each year from his pension. Divide that annual benefit by 12 months and Mr. Simmons figures out he’ll receive $2,500 each month for the rest of his life from his pension. Happy retirement, Mr. Simmons!

How Do I Know If My Pension Is Enough?

A lot of people want to know if their pension will be enough to take care of them in retirement. The answer is . . . maybe. It depends on a lot of factors. Here are some questions you need to answer:

• How much will your pension payments be? When do they start? (If you don’t know, the company holding your pension can help you find out.)
• Will you have other revenue streams, like IRAs or brokerage accounts, in addition to your pension?
• What is your current financial situation? Are you debt-free? Is your home paid off?
• What you want to do in retirement? What is your lifestyle expectation in retirement?

To get a real-time picture, you need to decide how much you think you’ll need each month in retirement, then subtract the amount of money you think you’ll have each month in retirement. How big is that gap? If your expenses are close to your projected payouts, then you’re on track. Keep doing what you’re doing or consider investing more.

However, if there’s a big difference between what you think you’ll need to budget for each month in retirement and the money you’ll have each month from a pension or your retirement fund, then you have three choices.

1. You can adjust your lifestyle expectations to match the amount of money you think you’ll have in retirement.
2. You can increase the amount of money you’re currently saving for retirement.
3. You can plan to work part-time to supplement your income in retirement.

Now, the third option may or may not be available to you. Life happens and may cut short your working years, so keep that in mind.

The best advice we can give you is to meet regularly with an investing professional you trust. They can track your financial progress and work with you to help you put yourself in the best financial situation possible. The older you get, the more often you need to meet with your investing pro to sharpen the focus on your retirement picture.

Preparing for the future takes planning, but it also takes hard work and ongoing effort. Your retirement is in your hands, so don’t let it slip away because you weren’t ready! Find a financial professional today.

What Are the Advantages and Disadvantages of a Lifetime Monthly Payment?

So, the biggest advantage of the lifetime monthly benefit is pretty obvious: You’re getting a steady income stream for the rest of your life. Some folks hear that and think “financial security.” And there is something reassuring about that.

You’re also not responsible for investing the money or any of the costs of managing your investments—that’s on your employer or whatever company is running your pension plan.

But there’s a flip side to that: Investment returns for pension funds usually underperform the stock market. Just look at state pension plans, which have an average rate of return of around 7% while the stock market averages between 10–12%.^2,3

Many pensions also don’t adjust for inflation, which means as the years go by and things get more expensive, your monthly checks won’t be able to buy what they used to.

But that’s not all. There’s another problem: Pension plans aren’t always a sure thing—not anymore. Some pension plans are either underfunded or in danger of becoming underfunded.⁴

And then there are workers and retirees wondering whether or not they’ll be getting their pensions at all because their companies are going bankrupt or facing financial problems.^5,6

And here’s probably our least favorite thing about pensions: They die with you. Sure, some pension plans offer spousal survivor benefits so your spouse would at least receive some money, but it’s usually just a portion of what your monthly benefit was. And what if you’re not married but have kids?

Unfortunately, your children probably wouldn’t get anything—your pension would simply go up in smoke.

What’s the big takeaway from all this? Don’t depend 100% on a company or the government for your financial security in retirement. Securing your retirement future is your job!

Ramsey Solutions is a paid, non-client promoter of participating pros.

How Does the Lump-Sum Payment Work?

The lump-sum payment is when you receive one large cash payment from your pension plan instead of receiving your pension in monthly installments. Think of it as a “buyout”—your employer is trying to get out of its future pension obligations by giving you one big payment now.

Like the lifetime monthly benefit, your lump-sum offer is calculated based on a set of factors. In this case, your current age, your salary, how long you’re expected to live and interest rates set by the IRS are a few of the numbers that employers use to figure out what to offer you in a lump sum.

Mistakes can happen, so make sure you take a real close look at your pension statement and verify that all the information is correct before you accept any lump-sum offer given to you!

Should I Cash Out My Lump-Sum Payment or Roll It Into a Traditional IRA?

Now, you basically have two options when you receive a lump-sum payment: You can cash out that money or you can roll the money over into a traditional IRA.

If you cash out the money, that will count as taxable income and you’ll most likely have to pay income taxes on that money right away. Depending on the size of the lump sum, that could add thousands of dollars to your tax bill.

Instead, we suggest rolling over that lump-sum payment into a traditional IRA so that your money can stay invested and keep on growing. (Why not a Roth IRA? Because a Roth IRA is an after-tax account, which means you would have to pay taxes on the entire amount you roll over from your lump-sum payment.)

That way, you could work with a financial advisor to help you pick good growth stock mutual funds to invest that money in. But remember, with a traditional IRA you’ll need to pay taxes when you make withdrawals in retirement later. Just keep that in mind!

What Are the Advantages and Disadvantages of a Lump-Sum Payment?

The great thing about the lump-sum payment is that it gives you control of your money. First of all, you can invest the lump sum however you want to and potentially earn a higher rate of return than the pension provided. And second, whatever is left of the lump sum when you die can be left behind for your spouse and your kids.

Are there any disadvantages to the lump sum? Well, taking a lump sum is a huge responsibility because there is less margin for error. A few bad decisions—like spending it all on a yacht or investing it in a single stock—and your lump sum could disappear or not grow enough to help you live the way you want to in retirement.

That’s why we always recommend working with a financial advisor to make the most of your lump sum. Not only can a pro help you steer clear of decisions that could derail your financial future, but they can also help you pick and choose investments for your portfolio.

Lifetime Monthly Payment vs. Lump Sum: Which One Is Better?

If your company declared bankruptcy, you changed jobs, you’re going into early retirement, or you just want more control over your retirement savings, cashing out your pension with a lump sum is a great option for you. That’s why the lump-sum option is the way to go in most cases.

The main difference between a lump sum and a monthly payment is that with a lump-sum option, you get to decide how your money is invested and what happens to it once you’re gone.

Let’s go back to Mr. Simmons and rewind the clock. He’s 45 years old now, still a couple of decades away from retirement, and his employer approaches him with a lump-sum option offer of $100,000. That’s a pretty big chunk of change!

He can take the money and run, but is it worth giving up his future lifetime monthly benefit in the process?

If Mr. Simmons took his monthly benefit of $2,500 a month at age 65 and lived another 20 years, by age 85 he would have received a total of $600,000 from his pension plan.

But if he takes the $100,000 early lump-sum buyout offer at age 45 and rolls it into a traditional IRA invested in good growth stock mutual funds, even if he didn’t put another penny into the IRA, he could have close to $900,000 by the time he retires at age 65—that’s about $300,000 more than his pension payments would be worth.

And just for kicks: If Mr. Simmons just invested $200 every month into the IRA from age 45 to age 65, it’s very possible that he would wind up with more than $1 million in his nest egg at retirement. That’s right: Mr. Simmons could become a millionaire if he plays his cards right—and so could you!

And if he passes away, whatever money is left can go to his wife and kids. If he stuck with his pension, his wife might be able to receive some form of monthly benefit from the pension . . . but then it dies with her.

The choice is pretty clear, don’t you think?

Work With a Financial Advisor

The only person responsible for securing your family’s retirement future is you. You have to make the most of your investments so that you won’t have to worry about running out of money in retirement.

If you don’t have a financial advisor to help you invest for retirement, you need one! That’s why the SmartVestor program exists: to connect you with a financial advisor or investment professional who can help you come up with a plan to reach your retirement goals.

 

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.