April was Financial Literacy Month, and why you likely saw articles with financial-planning recommendations, such as set goals, track spending, boost savings and understand concepts like "diversification" and "compound interest." Some articles may even have suggested you can "become a millionaire" by the time you reach Social Security age, if you follow the authors' advice.
Although those articles might be helpful, the Pension Rights Center is taking a different path. Instead of the standard advice, we will offer a multipart series discussing financial questions that you may not find elsewhere to tell you what you need to know if you have access to a retirement plan at work and hope to one day have a secure and dignified retirement.
In this first part of the series (the rest continued online at pensionrights.org), we will answer one of the top five questions that people looking for a secure retirement commonly ask us. Unless stated otherwise, answers relate to company-or union-sponsored private-sector retirement plans. We believe that being financially literate about your retirement plan is likely to pay off for your future.
Question: What is a pension plan and how is it different from a retirement savings plan, such as a 401(k)?
For workers who qualify for benefits, a pension plan (also known as a defined benefit plan) is the best financial tool available for achieving a secure retirement. Pension plans are set up by an employer (or by a group of employers and a union), and they typically provide lifetime-guaranteed income at retirement age based on the number of years you work and a percentage of your salary. Employees do not have to decide whether to put money into most private-sector pension plans. The contributions are made by employers as part of the wage package.
Unfortunately, fewer employers are offering defined benefit pension plans these days. They most commonly are found in unionized industries in the private sector and among state, local and federal employers. In a recent issue brief, the RRF Foundation for Aging said, "The private sector has not sufficiently supported workers' savings, and pensions, envisioned as a critical pillar of late life security, are increasingly rare."
Retirement savings plans, such as 401(k)s (also known as defined contribution plans), provide benefits based on the amounts contributed and investment earnings. Since these savings accounts are meant to provide retirement income, early withdrawals before age 59½ will usually result in a 10% penalty tax. To encourage contributions, many employers offer to match their employees' contributions.
One important difference between a pension plan and a retirement savings plan involves who bears the risk of potential investment loss. In a retirement savings plan, a worker typically chooses among different investment options and bears the risk of any losses. In other words, individual workers must decide whether and how much to contribute and which investment strategies to use, and then, come up with a sensible strategy to make sure that their money lasts through their retirement years.
In a pension plan, that risk falls entirely on those who fund the plan, usually the employer, which must pay a specific benefit under a formula set by the plan's consultants, no matter how the plan's investments perform. The federal Pension Benefit Guaranty Corp. provides insurance protection for most defined benefit pension plans that are unable to pay what they have promised. This protection covers a worker's pension benefits up to a set limit. If a plan decides to sell plan assets to an insurance annuity provider, which it has the legal right to do, retirees' annuity payments will be paid by the insurance company. If the insurance company becomes insolvent, retirees will receive protection up to the limits prescribed by their state's insurance guarantee fund.
There is no federal or state insurance protection for assets in retirement savings plans.
The U.S. Department of Labor has a fact sheet that explains the differences between pensions and retirement savings plans, profit-sharing and 403(b) plans which can be found at https://www.dol.gov/general/topic/retirement/typesofplans.
David B. Brandolph is the Pension Rights Center's senior communications consultant. More information and the continuation of the series can be found at pensionrights.org.