What Is a Pension Fund?

What Is a Pension?

A pension is a type of retirement plan that pays you a fixed monthly income when you retire. The pension is funded by your employer, or sometimes both you and your employer. This type of plan is known as a defined benefit plan because the benefit amount is calculated using a formula that considers your length of service, salary history and age at retirement.

Example: A company might offer a pension that pays 2% of your final salary for each year you worked. If you worked for 30 years and your final salary was $60,000, your annual pension would be $36,000: ($60,000 x 30) x .02.

It's important to understand how this defined benefit plan compares to a defined contribution plan, like a 401(k). Here's an overview of how these two retirement plans differ.

How Does a Pension Fund Work?

Pension funds are sponsored by employers, typically large corporations, government agencies and school systems. Depending on the plan, both employees and employers may contribute to the fund on a regular basis. Contributions may be mandatory or voluntary and are pooled into a professionally managed investment fund.

The pension fund invests in a mix of assets including:

• Real estate
• Global and private equity
• Hedge funds
• Other assets

A trustee or board oversees the fund, with the goal of growing investments while managing risk. Investment returns help ensure the fund can meet its future obligations to retirees. All growth within the fund is tax-deferred, meaning taxes are only due when funds are paid out.

Learn more: What Is a Tax-Deferred Retirement Account?

Pension Fund Payments in Retirement

Once you retire, the pension fund pays you a set monthly income, usually for life. These payments start at your plan's standard retirement age. You may be able to opt for early or delayed retirement, but the decision will affect the benefit amount:>

• Standard retirement: Full pension amount
• Early retirement: Reduced benefit based on your age
• Delayed retirement: Increased benefit to reflect additional service and delayed payments

You typically can't make lump-sum withdrawals from a pension fund while you're still employed, because pensions are designed to provide monthly income in retirement. Defined benefit plans don't offer individual account balances that you can tap into.

Some pension funds allow pension advances—a lump-sum loan against future benefits—but these are often risky and come with high fees. In some cases, you may be able to withdraw voluntary after-tax contributions you've made, if the plan allows.

To receive pension benefits, you must become vested, which means you've earned the legal right to keep your benefits even if you leave the employer. Most plans require five to seven years of service for full vesting. If you leave your job before you're vested, you may forfeit all or part of your pension. If you leave a job after becoming vested but before retirement age, your pension is typically frozen until you're eligible for retirement.

Learn more: What Is the Average Retirement Age?

What Jobs Offer Pensions?

Pensions have become less common in the private sector as many companies have shifted to defined contribution plans like 401(k)s.

Industries that may still offer pensions include:

• Government (federal, state and municipal)
• Military
• Public education and health services
• Construction and utilities
• Manufacturing
• Religious organizations
• Some financial and transportation sectors
• Personal and business services
• Information

Even within these fields, some pensions may be frozen, meaning they no longer accept new participants or accrue additional benefits.

Tip: Consider the type of retirement benefits an employer offers when assessing a job offer. Ask a potential employer what retirement benefits they offer and, if a pension is offered, how the pension works.

Pensions vs. 401(k)s

Both pensions and 401(k) plans help you save for retirement, but they work very differently.

Pension vs. 401(k)

Pension benefits are insured by the Pension Benefit Guaranty Corp. (PBGC), but only up to certain limits and if a private pension fails. By comparison, 401(k) accounts aren't insured against market losses, but they offer more flexibility and control over how and when you can access your funds. Some pensions include cost-of-living adjustments (COLA) to help offset inflation, while 401(k)s have no guaranteed increases. Instead, your retirement income depends entirely on your savings and market performance.

With a 401(k), you have more control over your savings. You can choose how much to contribute and select your investment options based on your risk tolerance, time horizon and what's available through your plan provider. The value of your 401(k) can change based on your investment choices, which can lower the amount of retirement savings you have. To maximize returns and minimize risk, you'll need to actively manage your portfolio.

Learn more: How Much to Save for Retirement by Age

Additional Ways to Save for Retirement

Besides pensions and 401(k)s, you can build retirement savings with other accounts and investments. Each option has pros and cons based on your income, employment type and retirement goals.

• Traditional IRA: Contributions to a traditional individual retirement account (IRA) accumulate and earn interest. Taxes on contributions and earnings are deferred until you make retirement withdrawals. Early withdrawals are allowed but are subject to penalties.
• Roth IRA: Contributions are made with after-tax dollars. Retirement withdrawals from a Roth IRA are tax-free. Whether or not you can contribute the annual maximum is based on your annual income, but you're allowed to withdraw your contributions anytime without facing penalties.
• Solo 401(k): Self-employed individuals can contribute to a solo 401(k) as the business owner and employee. These accounts offer high contribution limits and tax-deferred growth.
• Brokerage account: With flexible investing with no contribution limits, a brokerage account allows you to invest in a variety of assets, including stocks, bonds, mutual funds and exchange-traded funds. These accounts don't offer tax advantages, but allow you to access your funds any time with no penalty.
• Annuity: This investment provides guaranteed income in retirement, typically purchased with a lump sum or through installments. Annuities offer tax-deferred growth and can help supplement other retirement income.

Learn more: How to Save Money for Retirement

The Bottom Line

Pensions can provide long-term financial security with predictable income throughout retirement, but they're becoming more rare. If you have access to a pension, it can be a powerful asset. You can diversify your retirement strategy with additional savings through 401(k)s, IRAs and personal investments to help fund your retirement.