What Is a Pension Plan and How Does It Work?

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Depending on the job you have, there can be several benefits that you might be entitled to. One of those benefits is a pension plan if the company you work for offers it. 

Contributions made into a pension plan can help you achieve your savings goals for retirement. But, some pension plans vary depending on the employer. 

So what exactly is a pension plan, and how does it work?

What Is a Pension Plan? 

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A pension plan is a type of benefit that you can receive from your employer. It’s intended to help you save for retirement by making regular contributions into a pool of money. The funds then get set aside to pay eligible employees after they retire. 

Essentially, your employer makes contributions to the pension plan throughout the time you work for them. Then, after you retire, you receive a monthly income from the contributions made. You can also contribute a portion of your own wages to the plan if you want to. 

It’s worth noting that not all businesses offer a pension plan. That said, they can be most common within government organizations and large corporations.  

How Do Pensions Plans Work? 

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Your employer is required to contribute money to your pension plan as you work for them. After you retire, any accrued pension money that you earned gets divided into checks paid each month. It might depend on a few rules, but different variables can be taken into account. 

Things like your age, the total compensation amount, and how long you have worked for the company can affect the amount. But regardless, every pension plan must follow a set of rules set by the U.S. Department of Labor.

The rules were created to help control how much money a business can invest in employee pensions. The pension benefits you receive are also subject to a specific form vesting schedule, which can be a cliff vesting schedule or a graded vesting schedule. 

Types of Vesting Schedules 

With a cliff vesting schedule, you become eligible to receive 100% of your benefit once you get to a certain year. For example, if your employer has a five-year cliff vesting schedule, you won’t receive benefits if you decide to leave the company before the fifth year. But, if you stay longer than five years, you’re entitled to 100% of the benefits. 

A grading schedule, on the other hand, works a little differently. The longer you work for your company, the higher the earned benefit will be. For example, if your company has a seven-year graded vesting schedule, each year gets broken into percentages.

You might not receive any benefits for the first few years, but then receive 20% in the fourth year and so on. This happens up until you’re eligible to receive 100% of the benefits in the seventh year. 

Types of Pension Plans 

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When it comes to pension plans, there are two main types. These are a defined-benefit pension and a defined-contribution pension. 

With a defined-benefit plan, you know exactly how much you’re going to receive when you retire. This means that it can’t get impacted by how well or how poorly an investment pool can perform. Your employer ends up being liable for all payments, and the total amount gets based on how long you work for them and the salary you earned. 

In a defined-contribution plan, your employer contributes a specific amount that you end up matching. How much you receive after you retire depends on how well the investment is performed. 

The amount you end up receiving will depend on how much you contributed when you were working. Plus, it can get affected by external factors, such as fluctuating market conditions. 

Although not as common, there is also a pay-as-you-go type of pension plan. In this case, you fund the entire amount by choosing how much you want to contribute out of salary deductions. The downfall with this option is that your employer doesn’t match the amount you contribute. 

What are the Benefits of a Pension Plan? 

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The most significant benefit of a pension plan is it will provide you with a guaranteed income after you retire. This can help ensure that you have a financially independent life and don’t have to worry about your savings. 

When Do Pension Plans Payout? 

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How your pension plan gets paid could depend on the type of pension plan and how your employer sets it up. You can receive your pension in an annuity which is a monthly payout. This can be a good option since it’s a steady amount every month. 

You can decide to take a lump sum payment where you would take all the money at once. In this case, how much you spend or invest is based entirely on your decisions. It will all depend on whether or not you wait until the end of the plan or withdraw during the accumulation stage. 

You will usually receive payment on the last day of the month that your pension is effective if you choose to get paid monthly. After this, amounts usually get deposited two business days before the end of the month. 

What Happens to Your Pension When You Leave a Job?

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A few things can happen if you decide to leave your job. The biggest thing to keep in mind is that it will depend on your employer and the type of pension plan you have. 

If you are on a defined-benefit plan, you can transfer your pension plan to your new employer’s plan if they have one. You can also leave your pension plan with your current employer if it’s allowed. You can also decide to take your pension money and choose to invest it somewhere else. 

If you have a defined-contributions plan, you have the same options as a defined-benefit plan, but you can also buy an annuity. For example, you could purchase the annuity from an insurance company with a lump sum. They would then agree to pay you a certain income for a specific amount of time after you retire. 

Regardless of which option you choose, make sure that you keep all details of your pension plan and funds in a safe place.