How Does a Pension Work?

A pension is a type of defined benefit plan that provides guaranteed income in retirement. It’s an employee perk that’s largely faded out over the last few decades, at least in the private sector. Today, pensions are more common in government jobs. But if you are eligible for a pension, it can provide peace of mind in retirement for both you and your family.

How does a pension work? Let’s take a closer look, because understanding the ins and outs of this retirement benefit can help you get the most out of your pension and financial plan.

HOW DOES A PENSION WORK?

When you exit the workforce, you’ll likely lean on several sources of income to maintain your lifestyle. Money coming in from a pension is considered guaranteed income because you can count on it month after month. A pension generally lasts a lifetime, so, at least in this way, it isn’t unlike Social Security.

Unlike a 401(k), you typically don’t contribute to a pension during your working years — it’s a hands-off retirement plan that’s managed by your employer. With that said, you’ll generally have to work for a certain number of years before you’re able to collect it. Then, you can typically start to receive payments after you reach a certain age. The amount you get will depend on a number of factors like your age when you begin receiving your payments, your years of service, and your pre-retirement earnings. Some pensions are structured in a way that allows for larger payments if you work for a longer time period.

HOW LONG ARE PENSIONS PAID OUT?

Every pension is different. While monthly payments are standard and usually last a lifetime, there may be other ways to structure your payout. Your employer may provide a joint and survivor pension as an option. This generally translates to a lower monthly payout, but the upside is that payments will last until you and your spouse pass away. You’re sacrificing some income today so that your partner will continue receiving the same monthly benefit if they outlive you.

Some pensions may be structured to pay out fully every month for the rest of your life but reduce payments to your spouse after you die. Other pension setups allow you to take a lump-sum payment when you retire. It’s wise to check in with your employer so that you understand all your options long before it’s time to collect your pension. A financial advisor can work with you to develop an income-generating strategy that takes your pension and the rest of your financial picture into account when you retire.

ALTERNATIVES TO PENSIONS

If you don’t have access to a pension, you may want to consider an income annuity. Similar to a pension, income annuities offer regular monthly payments that typically continue for as long as you live.

Pensions and annuities are two potential ways to build guaranteed income into your retirement plan. However, a pension or an annuity on its own isn’t a comprehensive plan. You will likely want to have some savings invested in the markets, some held in cash, life insurance and other places. While they all serve a purpose in retirement, striking the right balance to ensure reliable income and adequate access to cash while also managing taxes and other risks like inflation or living too long. Teaming up with an experienced financial advisor can help you create a retirement income plan that’s tailored to your needs.