What is a pension?

A pension is a type of retirement account from employers. It provides a guaranteed stream of income in retirement, unlike the more common 401(k).

Derek Silva


Derek Silva

Derek Silva

Senior Editor & Personal Finance Expert

Derek is a former senior editor and personal finance expert at Policygenius, where he specialized in financial data, taxes, estate planning, and investing. Previously, he was a staff writer at SmartAsset.

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A pension is a retirement plan where an employer contributes a certain amount into a fund and invests it, on your behalf, so that you can receive a guaranteed monthly benefit (payment) when you retire. Pensions are a type of defined benefit plan. You will also see private pension plans referred to as pension schemes.

Pensions were once a popular perk for employees, but they have largely disappeared in favor of defined contribution plans. A defined contribution plan, like a 401(k), allows employees and employers to contribute but the employee is responsible for choosing the contribution amount and picking investments. There is no guaranteed retirement income.

The most common defined contribution plans are a 401(k) for private employers, 403(b) for public education or nonprofit organizations, and a 457(b) for governmental employers.

Private pensions are now rare, but public pensions are still common. Many municipal, state, and national government agencies provide a pension to their employees. Sometimes called retirement systems, these pension funds vary by location and occupation.

Key Takeaways

  • Pensions guarantee a defined payment every month in your retirement

  • You’re only eligible for a pension benefit if you’re with an employer long enough to vest

  • City and state pensions, called retirement systems, are very common

How a pension works

If your employer offers a pension, they will contribute a certain amount from each of your paychecks into a fund. You may also need to contribute, especially in the case of government pension systems.

An employer invests the funds on your behalf and you do not usually have a say in the investments. The goal is to grow the fund so that there is enough for employees to receive a lifetime monthly benefit when they retire. The Department of Labor (DOL) has guidelines on how much employers must invest.

Pensions work similarly to Social Security where the size of your benefit depends on how long you work at the employer and your salary.

As an example, an employer may provide a benefit equal to 1% of your average salary over the last five years of your employment there, multiplied by your total years of service. In this situation, your pension would be three times larger if you worked there for 15 years instead of five years.

However, you are not actually eligible to receive your lifetime pension benefit unless you work at the employer for a minimum amount of time. The process of becoming eligible to receive a pension is known as vesting and how long you have to work somewhere is the vesting period.

How pensions are invested

Employers with a pension with have a pension manager that oversees investment of the fund’s money. For private employers, the manager is often a financial advisor or institution. Investments for a public pension are overseen by a board of trustees.

No matter the employer, pension fund managers are responsible for investing so that the fund achieves a certain rate of return. They do this much like private investors do, with a diverse mix of fixed-income securities, equities, real estate, and alternative investments.

Fixed-income securities typically include investment-grade bonds and high-yield bonds. Investing in equities, like stocks, happens mostly through mutual funds and exchange-traded funds (ETFs). Stocks and funds can be risky, so specific attention goes to those with low fees and high dividends. Mutual funds are also used for alternative investments, like precious metals and other commodities. These assets may be too risky otherwise. Real estate is a very popular investment vehicle for pension funds. Real estate investment trusts (REITs) are common but larger pensions even have a department that helps purchase, develop, and manage actual properties.

Pension vesting

According to the DOL, the longest possible vesting period from a private employer is seven years. Public retirement systems usually have a vesting period of 10 years.

If you don’t work somewhere for the full vesting period, you may or may not get a partial benefit; it depends on your employer’s vesting schedule. There are two types of vesting schedules: cliff and graduated.

Cliff vesting vs graduated vesting

With cliff vesting, you only receive a benefit if you work somewhere for the full vesting period. Otherwise, you get no benefit. Private employers who use cliff vesting cannot have a vesting period of more than five years.

Graduated vesting gives you access to a partial benefit if you leave before the end of the vesting period. Some of your benefit vests each month or year, depending on your employer’s specific schedule. The maximum possible length for a graduated vesting schedule is seven years.

Let’s say your employer has a five-year vesting period with 20% of your benefit available after each year of employment. You’re eligible to receive 20% of your full possible benefit after one year, 40% after two years, etc.

The table below includes the DOL’s guidelines for the longest possible vesting schedule if a private employer uses graduated vesting.

Years of workMinimum amount of pension vested

Vesting when you leave your employer

If you leave an employer before any of your benefits have vested, you simply won’t get a benefit. This is the case whether you quit, you’re laid off, or you get fired. If you have made contributions to the pension, it’s possible that you can get a refund, depending on your employer and the circumstances of your departure.

When you leave your employer but return, you may be able to continue vesting right where you left off. An employer’s pension plan generally has to keep track of your service credit (how long you worked there) if you leave but return within five years. Returning after more than five years would mean you need to start vesting anew.

How to receive your pension benefit

When you retire, any employers who you are receiving a pension from will give you two options: receive the funds up front as a lump sum or receive them as an annuity (monthly payments).

Which you choose will depend on your personal situation. The lump sum gives you more control over your money. You can move the money into another retirement account, like a traditional IRA, and then use it whenever you need it. At the same time, you will have to pay a big income tax bill up front.

With the annuity option, you can’t get a larger payment if times get tough. Some people like having the regular monthly income, though. You can also minimize your tax bill because you only pay taxes based on what you receive in payments during a given year.

Income tax on pensions

Pension benefits are usually taxable income. You will pay federal income tax on them, with only a few exceptions. The most common is if you made any post-tax contributions to the pension. Only the pre-tax contributions are taxable in that case.

Not all states tax pension benefits, which is true whether they’re from a private or government employer. States that do tax them may offer exclusions based on your age or adjusted gross income (AGI). Check with your state’s tax department to learn more. This is important to check if you’re trying to decide between an annuity or lump sum payment.

For example, let’s say your state doesn’t tax pension income. You won’t pay income tax on monthly annuity payments. But if you take the lump sum up front and then roll over that money into a personal IRA, you will probably have to pay income tax when you withdraw from the IRA.

Public versus private pensions

Private pensions, provided by private companies to their employees, are not common anymore. But public pensions are still common. Cities, states, and the federal government offer pensions for certain public employees.

State pension funds are commonly known as retirement systems. Each state runs their own pension plan, so you should check your state’s website for more specific details. Many states offer two or three pensions, potentially including one for public school teachers, one for judges or legislators, and one for firefighters and members of the police force.

The federal government also offers pensions to public officials. Members of Congress, federal judges, and even the president receive a pension after they retire.

Public pensions may differ from private pensions in a couple of ways. The vesting period for public pensions is usually 10 years. Commonly, employees must make pension contributions once they have been employed for a certain amount of time. If an employee leaves within a couple of years, they may be refunded for their contributions.

Employees with a state or local government pension will receive lower Social Security benefits because of the Social Security Administration’s Windfall Elimination Provision (WEP). These government pensions and certain others do not usually require you to pay Social Security taxes, and so you cannot receive benefits based on the years you worked for that employe.

What happens to my pension if my company goes bankrupt?

If pension investments do not perform well or if the company declares bankruptcy, it is possible that employees won’t receive the benefits they were entitled to. This is unlikely, though. More commonly, employees will just receive smaller benefits.

Public pensions rarely go bankrupt because a government can use tax revenue to help pay benefits. Private pensions are almost always insured by the Pension Benefit Guaranty Corporation (PGBC), a federal agency. As with life insurance, employers pay regular premiums so that the PBGC can cover outstanding benefits in case of bankruptcy.

Pension payments after your death

When you pass away, what happens to your pension payments depends on your employer’s individual pension plan.

With a private pension, some benefits will pass on to a spouse or beneficiary. The surviving spouse or child should contact the pension administrator to make a claim on the pension benefits. The administrator will be able to provide details on how much they will receive, how they can receive it, and whether or not the money can be rolled over into another retirement account.

The spouse or child of a deceased wartime veteran may qualify for VA pension benefits from the U.S. Department of Veterans Affairs. This is known as a survivor’s pension, or death pension.

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Pension plans vs 401(k) plans

As mentioned, a pension is a defined benefit plan while a 401(k) is a defined contribution plan. Your employer likely offers one or the other, but it’s useful to highlight some of the differences between the two types of plans.

A 401(k) allows you to keep adding to your money by transferring it to another employer when you leave. You can either roll over your money into a new employer’s 401(k), or you can move it into a traditional IRA. This option is very unlikely with a pension. Instead, you probably won’t be able to touch any of your pension money until you retire.

Pensions also give you less control over your money because you cannot choose its investments. With a 401(k), you decide how to invest your money. However, 401(k) funds are generally less guaranteed because they rely on the performance of the stock market. When there’s a market downturn, you lose money. Pensions are guaranteed so even if the fund doesn’t perform well, you will probably still receive most or all of your benefits.

The main takeaway here is that a 401(k) or other defined contribution plan will give you more control over your savings and investments, but you should still take a pension if your employer offers it.