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Pension Plan Primer - What You Need to Know as You Approach Retirement

Pension plans are the cornerstone of many Americans' retirement savings, yet they aren't always understood. Since employers handle all of the admin work, it's easy to sit back and let money accumulate, without worrying about the details.

Pension plans are the cornerstone of many Americans' retirement savings, yet they aren't always understood. Since employers handle all of the admin work, it's easy to sit back and let money accumulate, without worrying about the details.

As you near retirement, you'll be faced with decisions on collecting your benefits. Before you make those choices, it's essential to understand your pension plan, the implications of each payout option, and how they fit your overall financial situation.

What Are the Major Types of Pensions?

Defined Benefit Plan 

When you hear "pension plan" you’re probably thinking about a defined-benefit plan. In this most traditional of pensions, the employer promises employees a specific payout upon retirement, based on salary and years of service. Defined-benefit plans are generally funded by the employer but require employees to work for a certain number of years before they are eligible to receive benefits. 

Defined Contribution Plan 

The other major type of employer-sponsored retirement plan is defined-contribution. In this case, employers commit to matching a certain percentage of the employee's contributions. The 401(k) and 403(b) are the most common defined-contribution plans. 

Two of the most important ways that a defined contribution plan is different are: 

  1. Employees are responsible for managing how their money is allocated
  2. The employer has no liability if the value of the investments drops 

While defined-benefit plans have become less common over time, especially in the private sector, they are still a great option for employees. Even in uncertain economic times, the promise of stable benefits significantly reduces your risk as you approach retirement.

How Does Vesting Work?

If your employer offers a pension, you're usually enrolled automatically within a year of starting at the company. However, it can take up to seven years to fully vest, which is when the money in your pension actually belongs to you. If you leave a job before vesting, you will likely forfeit some or all of the employer’s contributions.

There are three major vesting schedules for pension plans:

  • Immediate Vesting - As soon as money goes into your pension plan, it's 100% yours
  • Graded Vesting - Over the course of up to seven years, you become progressively more vested. For example, you might become 20% vested after one year, 40% after two years, and 100% vested after five years
  • Cliff Vesting - In this scenario, you become 100% vested after working a certain number of years but remain 0% vested until that moment

Once you're fully vested in your pension plan, the money is yours, even if you leave the employer before retirement.

When Do My Pension Benefits Start?

Pension payouts begin at the retirement age defined in the plan, which is generally 65 years old. Many plans have exceptions that allow early retirement benefits to start as young as 55, but you’ll get a lower payout than you'd receive if you waited until 65.

Unlike 401(k) plans, which allow for early withdrawals or taking out loans for home purchases, your pension benefits are inaccessible until retirement.

How Are Pension Benefits Paid Out?

Upon reaching retirement age, you'll choose whether to receive your pension benefits as a monthly annuity or a lump-sum distribution. Certain plans offer a hybrid model, where you take a partial lump-sum payment and receive reduced monthly benefits, but this is less common. 

Monthly Annuity

With a monthly annuity, you'll receive payments every month for the rest of your life. Many plans offer a survivor benefit, either to spouses or dependent children, but usually with a reduced payment. 

Lump-Sum Distribution

In the lump-sum distribution scenario, you receive a single payment for the full value of your benefits. At that point, the money is yours, and your employer has no further obligations. 

When taking a lump-sum payment, you should almost always roll the money into an IRA, as leaving it in a checking or savings account would immediately make the entire amount taxable. When it's moved into an IRA, it's still subject to Required Minimum Distributions, but it remains tax-deferred.

Choose your payout option carefully - in most cases, you can’t change it. There are a few exceptions, however. For example, the Colorado PERA pension plan allows you to alter your surviving beneficiary if you initially selected your spouse, but they pass away.

Which Payout Option Is Better?

Choosing between a monthly annuity or a lump sum will depend on how your pension fits into your overall retirement savings plan. One of the most important factors to consider is whether your other investments are taxable, tax-free, or tax-deferred. Rest assured, with the tax triangle approach you can spend strategically from all account types while minimizing the tax you owe.

For most people, taking a lump-sum distribution and rolling it into an IRA will be the best choice, as it provides the most flexibility. There are risks, though. The money becomes subject to market volatility, and you lose the comfort of guaranteed monthly income. 

With the assistance of a good financial advisor, you can select investments that fit your risk profile, reduce the amount lost to taxes, and ensure that your savings will provide for a comfortable retirement.

Want to learn more about managing your pension so you can enjoy retirement to its fullest? Get the 2020 Essential Retirement Guide today

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