What Is a Pension: Your Quick Start Guide
Pensions aren’t as common as they used to be. While many government jobs offer them, they’ve nearly vanished in the private sector. (In fact, a mere 15% of private-sector workers had access to one in 2023.)
But if you’re considering a job that offers a pension, it’s important to understand how they work.
What is a pension?
Pensions are employer-sponsored retirement plans that guarantee payouts in retirement. Since they define minimum benefit levels upfront, they’re also known as defined benefit plans.
Pensions require employers to contribute funds toward their employees’ retirement. This money is pooled and invested at the company’s discretion. Ideally, these investments generate income to pay for retirement payouts.
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The different types of pension plans
Traditionally, employer-funded plans are categorized as pensions, though many plans can help you save for retirement.
Defined-benefit plans
Traditional pensions guarantee employees a minimum level of income in retirement. Most benefit calculations use formulas that consider age, salary, and years of employment. Unlike other retirement plans, defined-benefit plans are funded primarily or solely by employers.
Defined-contribution plans
Defined contribution plans allow employees to divert some of their wages into retirement accounts. Employers can also contribute, usually up to a set percentage of a worker’s salary. 401(k)s are among the most well-known defined-contribution plans.
However, some defined-contribution plans also qualify as pensions. For instance, profit-sharing plans let employers share company profits with employees. As discretionary plans, employers can choose how much to contribute annually.
Public vs. private pensions
While increasingly rare, some private companies continue to offer pensions. To protect employees’ retirement, companies that offer private pensions must:
- Properly fund eligible employees’ pensions
- Keep pension funds separate from business funds
- Purchase pension insurance through the Pension Benefit Guaranty Corporation (PBGC)
Today, public pensions are far more common than private pensions. Around 34 million federal, state, and local government employees participate in these plans. This number includes former and current teachers, firefighters, and police officers, among others.
Unfortunately, public pensions don’t adhere to the same regulations as private pensions. As a result, many are underfunded, which impacts employees’ benefits.
How pensions work
Public or private, most pensions share a similar set of characteristics. Here’s what to know.
Contributions and funding
Unlike the more common 401(k), pensions are primarily funded by employers. Some plans allow (or require) employees to contribute some of their paychecks, too. These pooled contributions get invested into a professionally managed fund to grow until retirement.
Vesting schedules
Most pensions require funds to “vest” before employees can receive their full benefits. To become vested, you have to stay with the company for a minimum number of years. Companies may use one of two vesting schedules:
- Cliff vesting: All your benefits vest at once, usually after 5-7 years
- Graded vesting: A percentage of your benefits vest each year until you reach 100%
Importantly, if you leave the company before you’re vested, you lose your employer’s contributions. (Though you will receive back any money you’ve contributed.)
Spousal benefits
When it comes to spousal benefits, pension earners can choose from two payout schedules:
- Single life benefit plans only pay out to the pension earner. When they die, benefit payments cease. Any remaining employee contributions will be paid out to the deceased’s survivors.
- Joint and survivor benefit plans pay out as long as the pension-earner lives. Upon their death, their survivor(s) receive survivor’s benefits until they die, too. The survivor benefit may pay anywhere from 50% to 100% of the original pension payout.
It’s important to choose your plan wisely. Many pensioners choose the joint plan to ensure their loved ones are taken care of if they pass first. However, single-life benefit plans typically make larger payments.
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Understanding the relationship with Social Security
Technically, Social Security is a pension program funded by workers’ taxes. However, as of 2021, 27% of state and local government workers weren’t covered by Social Security. Since these workers have a public pension coming their way, they don’t pay Social Security payroll taxes, disqualifying them from SS benefits.
Payout options available
Your pension payout is based on a formula that considers your:
- Salary
- Years worked for the company
- Age
Once you retire, you may have one or two payout options: lump-sum distributions or annuities.
Lump-sum distributions
Lump-sum payments are what they sound like. When you retire, your employer pays your entire pension upfront. Then, it’s up to you to save, invest, and spend your pension wisely.
You might roll your payout into another tax-sheltered account, like an IRA. Or, you can pay taxes on the whole amount and stash the rest in a high-yield savings account or CD.
Some pensions only pay a partial lump sum equal to your contributions. The remainder of your pension will then be paid out as an annuity.
Annuities
Many pensions follow the annuity structure. Annuity pensions make regular monthly payments for the duration of an employee’s retirement. Annuities often pay a fixed amount and may or may not include inflation protection. If included, inflation protection adjusts your annuity payments based on the cost of living to prevent inflation from eating your hard-earned dollars.
Pensions vs. 401(k) plans
401(k)s are a type of defined contribution plan, but they are *not* the same as pensions. These investment accounts have largely replaced pensions in recent decades. The shift has allowed employers to shift the financial burden — and risks — of retirement investing to employees.
Funding differences
With traditional pensions, employers are responsible for fully funding employees’ retirement. Some pensions also permit (or require) employees to make contributions.
401(k)s, meanwhile, are funded by employees first. Some companies match an employee’s contributions to a point. (Usually 2-5% of an employee’s annual wages.) However, companies won’t invest if the employee doesn’t, pushing the retirement burden onto employees.
Benefits comparison
Pensions and 401(k)s both help employees save for retirement — but differ in several key benefits.
For one, annuity pensions provide monthly payments until the beneficiary dies. But 401(k)s require retirees to manage (or mismanage) their own funds for life.
The age of retirement also differs.
Pensions don’t allow you to withdraw funds until a specified age. Defined-contribution pensions may let you retire as young as 55. Some wait until you’re 65. Others set requirements like the “Rule of 80,” which states your age and years of service must add up to 80 before you can draw your pension.
By contrast, the IRS requires you to be at least 59.5 before withdrawing from your 401(k). Above that age, you can withdraw funds on your schedule. But making withdrawals before then (with limited exceptions) can trigger financial penalties.
Risks associated with pension plans
Pensions offer protections that 401(k)s simply don’t. However, they’re not risk-free.
Financial stability of pension funds
One major concern for pension earners is whether their employer will actually pay out. If the pension fund loses value or the company declares bankruptcy, your payments could be at risk. Even if your company has PBGC insurance, you may not receive your full benefits.
Public pensioners face additional risks. To start, many public pensions are chronically underfunded, limiting beneficiaries’ payments. Plus, public pensions don’t buy PBGC insurance, leaving former public servants without a safety net.
Inflation’s impact on pensions
Some pensions make cost-of-living adjustments to ensure benefits keep pace with inflation. But many don’t, which means your income won’t stretch as far the longer you live.
Lump-sum recipients also have to consider how to make their dollars stretch with rising prices. This may look like investing funds in high-yield savings accounts, TIPS, or other inflation-beating assets.
Tips for preparing for retirement
Whether you have a pension, 401(k), or another account, you shouldn’t wait for retirement to catch up with you. It’s important to get ahead — and stay ahead — so you can enjoy the retirement of your dreams.
Save early and often
The big key to preparing for retirement is saving as early and often as you can. Even if you can only stash a few dollars a month, that’s better than nothing! The earlier you start, the more time compound interest has to boost the value of your investments. And as you grow in your career and earnings, you can increase your savings to match.
Know how much you need
It’s wise to save for retirement — and even better if you have a goal in mind. Even if you don’t know exactly how much you’ll need, setting your sights on a target makes it more likely you’ll stay on track.
Evaluating retirement plan options during your career
You probably shouldn’t base your entire career around a retirement plan, but it can be a deciding factor. As you move up in your career, keep an eye on prospective employers’ retirement options. If it comes down to a pension or 401(k), evaluate what each account brings to your table. You might also consider tossing in an IRA (individual retirement account) to further boost your savings potential.
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Common pension FAQs
So far, you’ve gotten a good look at how pensions work. Now, it’s time to dive into some frequently asked questions.
How can I find out if I have a pension?
There are two easy ways to find out if you have a pension. The first is to contact your current or former employers’ HR department and ask about pension benefits. You can also search for an unclaimed pension on the Pension Benefit Guaranty Corporation website.
What happens to my pension if I change jobs?
Unfortunately, pensions aren’t very portable. If you change jobs, you may have to leave your pension behind and claim your benefits when you retire. Some companies let you roll your pension into another retirement account. But be warned: if you’re not fully vested, you’ll forfeit your pension when you leave.
Can pensions be inherited?
Yes, some pensions can be inherited. Joint and survivor benefit plans pay out partial or full pension benefits to spouses or other eligible survivors when a pension earner dies.
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About the Author

Anna Yen
Anna Yen, CFA, is Senior Advisor for Prudent Investors, a registered investment advisor for fiduciaries of trusts, estates, conservatorships/guardianships, and families. Over the last 20+ years, she’s held senior roles at UBS, JPMorgan, and asset management firms, along with founding personal finance blog Family Money Map and bilingual storytelling podcast Chinese Star Tales. Anna also serves on the Board of Directors for the Down Syndrome Diagnosis Network. She graduated with economics and computer science degrees from the Wharton School and Penn Engineering at the University of Pennsylvania. Anna’s worked in 5 countries and visited 57.