How Do Pension Plans Work?

Definitions

A pension is a method of financing retirement for workers. Workers pay a percentage of their salary towards the pension each paycheck. This is typically three to five percent per paycheck. In turn, the company the employee works for will help the employee finance his retirement.

There are two kinds of pensions. The first is called a defined benefits plan. The employer guarantees an employee will receive a given sum of money per month once retired. Money in pension funds may be invested in many financial vehicles. These include company stock as well as a broadly diversified portfolio of bonds and blue chips stocks.

The second kind of pension plan is called is called a defined contribution plan. Under this plan an employer agrees to match the employee's contribution to the pension plan but does not guarantee any benefits. Types of defined contribution employee pension plans include 401Ks and IRAs.

Benefits

A pension is an excellent way to plan for retirement. If the employee has a defined benefits plan, he knows exactly how much money he will have per month when planning for retirement. If an employee has a defined contribution plan he may have an additional yearly tax break as a result. He may also see the value of his pension plan increase, affording him a comfortable and stress-free retirement. Money provided by an employer for an employee pension is not taxed.

Vesting and Buy Backs

Pension plans are typically tied to an employee's tenure at a company. If an employee contributes to the pension plan for a given time frame, the employee is said to be vested. Vesting means the benefit is guaranteed by the employer and cannot be take away even if the employee leaves the company voluntarily or gets fired. This time frame required for vesting by many companies is typically at least five years. Some companies may allow employees to get vested in as little as three years. Some may require at least ten years of service to be eligible for a pension.

Some companies will allow employees to participate in a pension buy back plan. Workers are allowed to pay money into the system and have that sum counted as years of retroactive service. An employee may decide to purchase years of additional service. As a result of this purchase his pension is calculated as if he had worked at a company for twenty years rather than eighteen. In general the longer one has worked at a company the greater dollar amount of the pension upon retirement.