There are two main types of retirement plans: defined contribution and defined benefit. With a defined contribution plan like a 401(k), you bear the investment risk and your retirement balance depends on how those investments perform. A defined benefit plan, or pension, flips that risk to the employer. Instead of building an account balance, you are promised a set income in retirement, often based on your salary and years of service. Many pensions also include inflation adjustments and sometimes retiree health benefits, which can be difficult to replicate on your own.
Pensions come with tradeoffs. They are not flexible and the money is not directly under your control. You typically need to stay with the employer long enough to vest, and benefits are not portable if you change jobs. There is also some risk tied to the employer’s financial health, although partial protections may exist. While pensions used to be common, they have largely disappeared outside of government and military roles. Employers moved away from them to reduce risk and costs, and many employees have historically undervalued retirement benefits compared to higher salaries.
When incorporating a pension into your financial plan, it is usually best to treat it as a guaranteed income stream rather than trying to assign it a portfolio value. Subtract your pension and Social Security income from your expected spending needs to determine how much your investments must cover. If offered a lump sum instead of a pension, a helpful comparison is to estimate what it would cost to buy a similar annuity. While pensions are not perfect, they can provide a valuable income floor in retirement and reduce the pressure on your investment portfolio, especially when paired with other guaranteed income sources.
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There are two main types of retirement accounts. There are defined contribution accounts and defined benefit accounts. A defined contribution account is your typical 401(k). You put money in, and depending on how well your investments do, that is how much money is in the account later for you to spend. The other type of account is a defined benefit plan, defined benefit account, or defined benefit retirement plan. This is a plan where the employer is taking the risk rather than you taking the risk of how well the investments do. The employer has promised you, rather than a defined contribution into the account, a defined benefit from the account. So if the investments do really well, the employer gets to keep the extra. If the investments do not do really well, the employer has to make up the difference. This is a classic pension. You go work for the employer for 20 or 30 years, or whatever it might be, and they pay you a pension for the rest of your life.
The nice thing about these pensions is they tend to have an inflation adjustment aspect to them, not always, but often, which is difficult to get these days. You cannot necessarily buy that from an insurance company. You can get it from Social Security, especially if you delay your Social Security to age 70, then you can get a comparable inflation-indexed benefit. But typically, you can only get that from a pension. Sometimes the pension also includes some sort of employer-provided healthcare benefit as well, some type of health insurance that may be in addition to your Medicare or instead of Medicare, or something like that. But that is what we are talking about when we are talking about a pension.
The downside to a pension is it is not your money. You do not get to decide what to do with it. For example, if it was your 401(k), you could just take all the money out today and buy a sailboat if you wanted to. A pension is not that flexible. The other big risk with a pension is that something happens to the employer. If that happens, your pension could go away. Now there are some semi-government entities, often groups of pension funds or insurance companies banding together, to guarantee these sorts of things, but they usually only guarantee a certain amount. So if your employer goes out of business, you are probably still losing something. That becomes an issue when you are given the option to take your pension as a lump sum and have the money you now control, versus the guarantees provided by the pension where the company is taking the risk on the investments. That can be a challenging decision.
The problem with pensions is they are mostly not available anymore. It used to be you would go work for a company, put in your time, and qualify for your pension. It was wonderful, and lots of people had pensions. They might have had some savings in addition, but they mostly lived on their pension and their Social Security. This is what my father had. My father worked for the State of Alaska for a long time and qualified for a pension, and that is what they live off of. They live off the pension and Social Security and do not even really touch their nest egg. That is not the case for most workers today. Their companies do not offer pensions. Typical places you can get a pension are usually government employers, such as the military or a state entity. There are still some companies that offer them, but for the most part, you do not see them as often as you used to. They really are disappearing. The main reason is that companies did not want to have that risk on their books, and they thought they could get away with putting less toward the retirement of their employees. The truth is most employees do not care nearly as much about retirement benefits as they should. They will often prioritize getting a higher salary rather than a higher retirement benefit, and that is a major reason pensions are disappearing.
Every pension is different, and you have to read how your pension is actually calculated to understand it. A typical way it might be done is by looking at your last three years of work for that employer and calculating your average salary during that time. Then they might give you, for example, 50% of that average as your pension. If you were earning $100,000 per year on average during those last three years and it paid 50%, you would receive a pension of $50,000 per year, which is just over $4,000 per month, often indexed to inflation. They can structure it however they want. They can start paying after five years, or make you wait 20 or 30 years. That is up to them. Usually, the idea is to create golden handcuffs so employees stay longer to qualify. When you qualify, that is called being vested in the pension. Vesting means you now have the right to receive the pension. Until you reach that minimum number of years, you are not vested, and if you leave before then, you may not get the pension at all or may receive a reduced benefit. These plans are typically not portable. If you change employers, you usually start over rather than taking those years with you.
How should you think about a pension in your overall financial plan? Some people try to assign it a value and treat it like the bond portion of their portfolio. I would recommend against doing that. Instead, take all your guaranteed sources of income and subtract them from what you need to spend. For example, if you need $120,000 per year in retirement and your pension plus Social Security will provide $60,000, then you only need $60,000 from your portfolio. That is a simpler way to think about it. Having a pension does affect decisions like when to claim Social Security or whether to do Roth conversions, because pensions fill up lower tax brackets and can push other income into higher brackets. If you qualify for a pension, you may be more likely to make Roth contributions or conversions and may choose to delay Social Security, especially for the higher earner. However, if your pension is large enough, you might make different Social Security decisions.
Many people are offered a lump sum instead of a pension, such as choosing between a monthly pension or receiving $600,000 today. One way to evaluate this is to see what it would cost to buy an equivalent annuity. If purchasing a comparable annuity would cost $800,000 and the lump sum offered is $600,000, that suggests the pension may be the better deal. It is not always a perfect comparison, especially if the pension includes inflation adjustments, since many annuities do not. But it provides a useful framework for making the decision.
Although there are risks, pensions have benefits. They provide a guaranteed income floor, similar to Social Security, which can help ensure basic expenses are covered regardless of investment performance. That guarantee has real value, especially when compared to safe investments like CDs or Treasury bonds. Another interesting observation is that people who receive lifetime income streams, such as pensions or annuities, tend to live longer. It may be that healthier people are more likely to choose these options, but the data does suggest a correlation. This is something to keep in mind when deciding whether to take a pension or a lump sum.
Hope that is helpful and helps you understand how pensions work.
The White Coat Investor podcast is for your entertainment and information only and should not be considered financial, legal, tax, or investment advice. Investing involves risk, including the possible loss of principal. You should consult the appropriate professional for specific advice relating to your situation.
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