What Is a Pension & How Is It Calculated?

Many employers fund pension plans for employees as part of their benefit packages. If your employer provides you with a pension plan, you typically must calculate your benefits using a formula established by the company. This formula usually is based on the number of years you have worked for your employer and the amount of money you earned.


About Pensions

A pension is a type of defined benefit plan, which is a retirement account funded entirely by your employer. While you are working, your employer contributes to your pension plan regularly. In most cases, your employer also decides how to invest the funds. Most pension plans don't allow you to access the funds until you reach retirement age, usually 65. However, a few plans may allow early access to a reduced from age 55 to 65.


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Before you can calculate the amount of pension benefits you will receive each month, you must determine the percentage of your benefits that were vested, or guaranteed, before you left your job. Most pension plans use either cliff vesting or graded vesting. Under cliff vesting you forfeit all of your pension benefits if you leave your job in less than five years. If you leave after five years, however, you are entitled to all of your benefits upon reaching retirement age. Under graded vesting, you are entitled to 20 percent of your benefits if you stay at the job for at least three years. During each following year, another 20 percent of your benefits become vested.



Most employers calculate your pension benefits based on the product of your years of service, a multiplier the company determines and your earnings during the three years that you earned the most. For example, if you worked for a company for 25 years, earned an average of $5,000 per month during your highest paid period and the company's pension multiplier is 2.5 percent, your full pension benefit would be $3,125 (25 years x $5,000 x 0.025). However, if you elect to receive benefits before age 65 or if 100 percent of your benefits aren't vested, your monthly payment may be less than this amount.


Social Security Offset

Because your employer is responsible for paying half of your Social Security taxes each month, many companies that provide pension plans reduce your monthly benefit based on the amount you are entitled to receive from Social Security. This offset is determined by your employer and can equal up to 50 percent of your monthly Social Security benefits at retirement.



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