How Does a Pension Work?
Jason Stolz CLTC, CRPC
Many of our clients ask us “How Does a Pension Work?” A pension is a retirement plan that provides a guaranteed stream of income for life, funded by employer contributions, investment earnings, and sometimes employee payroll deductions. Pensions—also called defined benefit plans—promise a specific payment in retirement based on your salary history, years of service, and age at retirement.
While traditional pensions have become less common in the private sector, they remain a vital part of retirement income for teachers, firefighters, federal employees, and others. Understanding how a pension works—and how to coordinate it with other income sources such as 401(k) savings or annuities—is key to building a secure, tax-efficient retirement plan.
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Pension Basics: Defined Benefit vs. Defined Contribution
There are two main types of employer-sponsored retirement plans—pensions (defined benefit) and contribution-based plans like 401(k)s or 403(b)s. Here’s how they differ:
| Feature | Defined Benefit (Pension) | Defined Contribution (401k/403b) |
|---|---|---|
| Who contributes | Employer (sometimes employee) | Employee (and possibly employer match) |
| Investment risk | Employer bears the risk | Employee bears the risk |
| Benefit formula | Salary × Service × Multiplier | Depends on investment performance |
| Guarantees | Lifetime income guaranteed | No guaranteed lifetime income |
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Vesting and Eligibility
Vesting determines how long you must work before you own the right to your pension benefits. Most plans use a graded or cliff vesting schedule—often between 3 to 7 years of service. Once vested, your benefit cannot be forfeited, even if you change jobs.
How Pension Payments Are Calculated
Pension benefits are based on a formula—typically your final average salary multiplied by a percentage (accrual rate) and years of service. For example:
Example: A 30-year employee earning an average of $70,000 with a 1.8% multiplier would receive:
30 × 1.8% × $70,000 = $37,800 per year for life.
Some plans allow survivor or joint-life options, reducing the monthly payment slightly to cover a spouse after death.
Pension vs. Private Annuity: Key Differences
- Pensions are sponsored by employers; annuities are purchased individually.
- Pension income is fixed; annuities offer index-linked or inflation-adjusted options.
- Pension benefits usually end at death (unless a survivor option exists), while annuities can include a death benefit for heirs.
- Private annuities can supplement pensions, helping retirees manage inflation and provide liquidity or legacy benefits.
Tax Treatment of Pension Income
- Pension payments are generally taxable as ordinary income.
- Roth accounts within federal pensions (such as a TSP) may allow tax-free withdrawals.
- Some states offer partial or full exclusions for pension income.
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FAQs: How Pensions Work
Is pension income guaranteed for life?
Yes. Traditional defined benefit pensions pay a guaranteed monthly income for life, often with options for joint or survivor benefits.
Can I roll my pension into an annuity?
Yes. Some retirees use a direct rollover to transfer a lump-sum pension payout into an annuity to preserve tax deferral and lifetime income options.
What happens to my pension if I leave my job?
If you are vested, you’ll retain your earned benefit. Some plans allow deferred benefits; others offer a lump-sum payout.
Are pension payments taxed?
Most pension income is taxable at ordinary income rates. Roth components or state exclusions can reduce the burden.
What’s the difference between a pension and an annuity?
Pensions are employer-funded plans; annuities are individual contracts. Both provide guaranteed income, but annuities offer more customization.
