Retirement Primer: All You Need to Know About Pensions
One great way to plan for retirement is through a pension. A pension provides a source of income after you retire, helping to ensure financial stability when you’re no longer employed. However, pensions can be complicated, so it’s important to understand how they operate and factors to consider for your retirement planning. Here’s what you need to know about pensions.
What is a pension?
A pension is a retirement plan that provides you with a regular income after you stop working. Contributions are made throughout your working life by you, your employer or both parties. Pensions are typically long-term investments that benefit from compounding growth, which means your savings can grow exponentially over time. Most pension plans have tax advantages as well, either allowing for tax-free growth of your investments or tax-deferred contributions.
Types of pensions
There are two primary types of pensions. Understanding the differences between them is crucial to planning for your future.
1. Defined benefit (DB) pension
A defined benefit pension guarantees a specific amount of money during retirement. The amount you receive is typically based on factors such as your salary, the number of years you’ve worked for the company and a fixed formula that’s set by your employer.
For example, a DB plan might offer a benefit equal to 1.5% of your average salary for each year of service. If you worked for 30 years and earned an average salary of $50,000, you would receive $22,500 annually in retirement.
Defined benefit pensions are considered secure because the employer bears the investment risk. However, they are less common in the private sector today, though still prevalent in government jobs.
2. Defined contribution (DC) pension
A defined contribution pension doesn’t guarantee a specific payout at retirement. Instead, both the employee and employer contribute a fixed amount or percentage of the salary to an individual retirement account. The final amount you receive depends on how well your investments perform. DC pensions are more common in the private sector.
Examples of defined contribution plans include 401(k) and 403(b) plans. In these plans, employees typically choose how their money is invested, often in a selection of mutual funds, stocks or bonds.
A key advantage to DC pensions is their flexibility. You can adjust how much you contribute and where you invest your funds based on your risk tolerance and financial goals.
Tax benefits of pensions
One of the major advantages of pensions is their tax treatment. In most cases, contributions to your pension plan are made on a pre-tax basis, meaning you’re not taxed on that income until you withdraw it in retirement. This defers your tax liability to a time when you may be in a lower tax bracket.
Additionally, many pension plans offer tax-free growth, meaning any investment gains within the pension fund aren’t taxed as long as the money remains in the account. This allows your savings to compound more quickly, giving you a larger nest egg for retirement.
How much should I contribute to my pension?
The amount you should contribute to your pension depends on several factors, including your income, retirement goals, and the type of pension plan you have. A good rule of thumb is to aim for saving at least 10-15% of your income each year.
If your employer offers a matching contribution—which is common in defined contribution plans like 401(k)s—try to contribute at least enough to get the full match. For example, if your employer offers to match 50% of your contributions up to 6% of your salary, contributing at least 6% allows you to maximize this “free money.”
How do pensions differ from other retirement accounts?
While pensions are a great tool for retirement planning, they aren’t the only option. Many people also save for retirement through other accounts, like IRAs (Individual Retirement Accounts) or taxable brokerage accounts. The key difference between these accounts and pensions is that pensions are usually employer-sponsored, while IRAs and brokerage accounts are set up and managed individually.
If you do have a pension plan, it can be a good idea to set up additional savings vehicles, such as an IRA, to supplement your retirement income. This will help ensure you have sufficient savings to live off when you retire.
Pensions can be a powerful tool for ensuring a financially secure retirement, but it’s important to understand how they work. Use our guide to learn all you need to know about pensions.