How Do Pensions Work?
If you’ve been diving into retirement planning, you’ve probably come across pensions as a potential source of income for your future. However, you may be wondering: How exactly do pensions work, and can they help me plan for my retirement? Pensions are becoming increasingly rare, but can still be a valuable part of retirement planning if available. Unlike retirement accounts like IRAs, you can’t open a pension on your own. Let’s break it down and explore how pensions contribute to retirement funding if you’re lucky enough to have one.
Pensions Are Becoming Less Common
Pensions used to be the cornerstone of retirement for many American workers, offering a reliable income once you stopped working. Until the 1980s, most employees could count on receiving a pension — a steady stream of income based on how many years they worked for their employer and their earnings at the end of their career.
But in 1978, the U.S. tax code changed with the Revenue Act. This law introduced Section 401(k) of the Internal Revenue Code, which allowed employees to defer compensation and save for retirement in a tax-advantaged way. This shift essentially marked the end of the pension era for most Americans, as companies began favoring 401(k) plans instead. Today, the vast majority of retirement savings are through 401(k)s, rather than pensions.
The Three-Legged Stool
When financial planners talk about retirement, they often refer to the three-legged stool of retirement income: pensions, 401(k)s/IRAs, and Social Security. Ideally, these three sources of income work together to provide financial stability in retirement. However, pensions are no longer the reliable leg of the stool they once were for most people.
If you’re lucky enough to have a pension, it’s a guaranteed monthly payment from your employer once you’ve worked for them for a certain number of years. The beauty of pensions is that they take some of the responsibility off your shoulders — you don’t have to worry as much about saving for your future because the employer has already set up a payment plan for you. These pensions are still common in government roles, education, some medical professions, and union jobs.
Changing Careers and Pensions
Pensions are a relic from an era when many people stayed with the same employer for most of their careers. But in today’s job market, it’s much more common for people to switch jobs throughout their careers. This makes 401(k)s more practical since they can be rolled over into new accounts when you change jobs.
If you’re leaving a job that has a pension, you’ll face a decision. You might be able to take a lump sum payout or roll the pension over into a 401(k) or IRA. This is where a CERTIFIED FINANCIAL PLANNER™ can come in handy to help you make the best decision for your specific situation and retirement goals.