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How Do Pensions Work?

Do you receiving a pension? Are you paying into one? If so, do you know how they work?


how pensions work

What Is It?


A pension is what is called a defined benefit plan, meaning the benefits to you are defined. The benefits are defined no matter what happens in the markets.  This used to be how the majority of us were able to retire in the past. Over time companies have grown to offer what are known as defined contributions plans instead (403(b), 401(k), etc.). That is, your contributions are defined - usually as a percentage of your paycheck, but your benefit depends on what the investment markets do between now and when you need the money. 


So essentially you pay in with each paycheck and the company usually matches a portion of it. Then at retirement you get monthly paychecks for the rest of your life. It's important to note that with pensions, the investment risk lies with the company and not with you. 


Comparison To Social Security And Annuities


You may have read that and thought to yourself that these sound a lot like Social Security or an plain annuity. Congratulations! The underlying system is the same. Social Security is effectively a government-fun pension plan. Annuities offer the same benefit in the you can pay some money each month and get paychecks each month when you retire (alternatively, you can pay a lump sum in exchange for monthly paychecks). All three of these systems offer similar payout options and they all offer payments for your life. 


Options Exist, But You Get a Smaller Check


If you want payments to last longer than just your life, or if you want to make sure your payments last a certain amount of time or so that you at least get your deposits back, you can usually do that. To do that, though, will cost you money in the form of smaller monthly paychecks.


For example, if someone with a pension chooses the main option, the paychecks stop after that person dies. That means that if the surviving spouse lives longer, though, there is no income for that spouse. By choosing the option where the paychecks last until the second spouse dies, you make sure there is income for both of your lives. The trade-off, of course, is that the monthly paycheck will be lower. That makes sense because your household may be getting more paychecks over time. 


As with anything, you have to make sure any option you choose works for you and your situation. Consider this situation: if you have a family history of living a long time and choose the option to guarantee your payments for 10 years, you get a smaller paycheck for the rest of your life. You were likely going to live that long anyway so you just effectively lowered your payments. Now, just because that's the math doesn't mean it's necessarily right. If you would be worried about dying too early and not getting 10 years worth of payments, then it may be the right thing to do. The smaller check is how much it costs for peace of mind. 


The Math Department Determines Y