What is a Pension? Everything You Need to Know

October 7, 2020

A pension plan is an employer-sponsored retirement plan distinct from the more common 401(k). Pension plans were widespread before the 1980s, but have been steadily declining since then.

Defined Benefit vs. Defined Contribution Schemes

A traditional pension is known as a defined benefit plan. They are called this because both the employee and the employer know in advance the benefit formula used in the benefit payout.

A pension is simply a retirement account where your employer contributes a set amount of money for you to access when you retire. The opposite of this is a defined-contribution plan, where you are required to invest a portion of your salary into the account yourself (like a 401(k)).

Defined benefit plans are considered better than defined contribution plans, but fewer people today have access to them. Defined-benefit plans have been dramatically scaled back in recent decades due to how costly they are for employers.

Traditional Pensions vs. Cash Balance Plans

Defined-benefit plans come in two varieties: cash balance plans and traditional pensions. In either case, you just have to meet the plan's eligibility requirements and show up to work, and you'll be automatically enrolled in the plan. However, the types differ in how the benefits are calculated. With a pension plan, a formula is used to determine your benefit. This formula may include factors such as:

  • How long you have worked on the job (time in service).

  • The final average salary.

  • A benefit multiplayer.

The final average salary can vary from scheme to scheme. In some pension plans, an average of the last 3-5 years of employment is taken. In other plans, they will use the highest average salary the employee got during their service.

In cash balance plans, your retirement account is credited with a set percentage of your salary each year.

Getting "Vested" in the Plan

Vesting is the process by which you gain the full benefits of a pension plan. Some plans will vest the benefits immediately, while other plans will spread vesting out over many years. Pensions typically use one of two vesting schedules; cliff vesting and graduated vesting. 

With cliff vesting, you become fully vested in your pension after a certain number of years have passed. For example, let's say you stay at a company for three years, but this company has a five-year cliff vesting schedule. Before you haven't met the 5-year requirement, you will not receive any of your employer's contributions. However, if you contributed yourself, you are still vested in your own contributions.

With graduated vesting, unlike cliff vesting, you're not required to cross one significant milestone like the fifth anniversary. Instead, you become partially vested for each year of service after year 3. After three years, you become at least 20% vested in your pension in the private sector. At year 4, this goes up to 40%, and then 60% in year five, and 80% in year 6. At year 7, you are 100% vested in your pension plan[1]. Your employer may offer a more generous vesting schedule if they choose to do so.

Rahul Iyer

[1] https://www.investopedia.com/retirement/pension-vesting-everything-you-need-know/#:~:text=Participants%20in%20a%20defined%2Dbenefit,or%20a%20gradual%20vesting%20schedule.

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