How Does a Pension Plan Work?

Because the defined benefit pension plan is less common today than the 401(k) plan, there’s general confusion about how pension plans actually work.  The defining difference is that a pension plan promises a specific benefit (such as monthly income) to participants, while a 401(k) plan has no such guarantee.

Unlike a 401(k) plan, a defined benefit pension plan does not establish individual accounts for participants. Instead, it combines all contributions and investment earnings into a large pool. This pool provides the benefits for all who are covered.

Calculation of Pension Plan Benefits

Each year, the covered employee receives a benefit statement and plan description. The exact pension formula varies among companies, but the size of the eventual pension benefit is typically based on three factors:

  • the number of years the employee spends with the company;
  • the employee’s average earnings over his or her tenure or his or her peak earnings with the firm, or some combination of these two factors; and
  • the age of the employee when he or she starts to receive the pension benefits.
pension plan

© Martin Heaney / Fotolia

Not all pension plans calculate benefits in exactly this way. One plan could use the average salary for the entire career rather than just the final three or five years. Or, a plan could use a different multiplier. Some plans even disregard earnings altogether and simply multiply a preset dollar amount by the number of years the employee was with the firm. Virtually all pension plans have additional rules and requirements that can affect the eventual size of the pension benefits that a person receives.

Limitations on Pension Plan Benefits

Regardless of the method used to determine the ultimate benefit, the benefit is subject to statutory limits imposed by tax law. Consequently, the plan must ensure that actual benefits paid to retirees do not exceed these levels. Annual defined benefit pension payments to any retiree are limited to the lesser of

  • one hundred percent of the retiree’s average compensation in the high three consecutive years of employment; or
  • $195,000 (as of 2011; the amount is indexed for inflation).

As noted, the retirement benefit payout from a defined benefit usually takes the form of monthly payments. Typically, these benefits are payable over the joint lives of the participant and his or her spouse. If desired, the participant and spouse can actively elect payments to extend for only the life of the participant, in which case they could be slightly higher than those under the joint payout.

Pension Plan Vesting

Every defined benefit plans include a vesting period. A vesting period is the number of years that an employee must spend with the employer before he or she becomes entitled to the plan’s benefits. If the employee leaves the company too soon, he or she might not be entitled to anything. Including a vesting period in their pension plans is a way for companies to encourage their employees to stay with the firm.

Vesting formulas for defined benefit plans are likely to take one of two forms:

  • cliff vesting—With this vesting schedule, employees become fully vested after five years with the firm. This arrangement is also known as all-at-once vesting. With such a plan, if the employee leaves the company after four years and 11 months, he or she will probably receive no pension at all. If the employee were to stay one month more, he or she is entitled to 100 percent of whatever benefit has accrued.
  • graded vesting—Under a graded vesting schedule, the plan participant becomes vested gradually, in increments, in his or her accrued benefits. Typically, a graded vesting schedule provides for the following:

0 to 2 years of service — 0 percent vested
3 years of service — 20 percent vested
4 years of service — 40 percent vested
5 years of service — 60 percent vested
6 years of service — 80 percent vested
7 years of service — 100 percent vested

Pension Plan Funding

As noted, the employer usually funds defined benefit pension plans. The benefits are set in advance and are to provide for annual income, payable monthly, throughout a participant’s retirement. As a result, the contribution levels are actuarially determined so that a fund sufficient to provide each participant with his or her promised pension gradually accumulates.

Typically, employer contributions are made annually in amounts that are at least the value of the benefits that plan participants earned that year. The amounts account for:

  • employee compensation levels
  • investment performance
  • years until retirement
  • life expectancies after retirement

Contributions must meet minimum funding standards and are mandatory.

Retirement Planning Issues

Most defined benefit plans are not as generous as they may first appear, because today very few pensions account for inflation. Rarely do we see a defined benefit pension plan which has inflation adjustment built into their benefit payments.

This reality translates into three important considerations for a participant’s retirement planning:

  • Participants must not assume that a defined benefit pension will replace a majority of his or her retirement income.
  • A participant should consider leaving the bulk of his or her private retirement savings untouched for the early years of retirement.
  • A participant should consider putting a portion of the pension benefit he or she receives during the early retirement years into savings. Then this amount will be there when the real value of

Even if one’s company goes out of business or its pension fund runs short of cash, the benefits payments are likely backed by the Pension Benefit Guarantee Corporation (PBGC), a quasi-governmental agencey.

While less common than in the past, pension plans continue to exist and participants need to have an understanding of how they work. Plan Sponsors may be unaware that they can offer both a defined benefit pension plan as well as a 401(k) defined contribution plan to their employees.  If offering both types of retirement plans, a plan sponsor needs to carefully coordinate benefits and plan documents.

As Employee Benefit Specialists, we are happy to answer pension plan questions from plan sponsors. 

Related Topics
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About Rick Holden

Rick Holden is a principal member and helped to establish the San Francisco office of Cambridge in 2002. Rick holds the Registered Representative and the Investment Advisor Representative designations by having passed FINRA’s Series 7 and Series 65 exams respectively. He is also a licensed insurance agent and designs comprehensive insurance plans for clients.


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