How Do Pensions Work?—Your Ultimate Guide

Before the 1970s, pensions were the standard retirement benefit offered by employers.

But today’s mobile workforce—as well as the high cost of pension plans to the employer—have caused the number of pension plans to decrease over the years and to be replaced by 401(k)s and similar types of portable retirement plans with account balances (called defined-contribution plans).

But for those who still have them, pension plans can be a great retirement benefit.

Start relaxing about retirement by scheduling a 15-minute call with one of our advisors here.

By Michael Sharpnack

The key decision with your pension is when and how to take it.

You must decide what age to start benefits and which payout option to choose from.

In order to make that decision, you must understand how pensions work:

• How pension payout options work
• When you can start benefits
• How pension benefits are calculated
• Cost-of-living adjustments
• How to compare the lump sum with monthly payments
• Is your pension secure?
• How to choose the when and how of your pension

Pension Payout Options

Your employer can offer many different ways to receive your pension benefits in retirement.

The choices vary widely per employer. Some may offer ten or more options, while some may offer only one or two.

Pensions either pay out as an annuity—periodic payments over time—or they can pay out as a lump sum.

Most all pension payouts can be classified under the follow options:

• Annuity (monthly payment options)
  1. Single life
  2. Joint-and-survivor
  3. Period certain
  4. Social Security leveling
• Lump sum
• Hybrid (partial lump sum with reduced monthly payment)

Single Life

This is the standard pension option.

With the single life option, you receive a stream of monthly payments for life. Once you die, the payments end. But as long as you’re alive, the payments keep coming.

The advantage of the single life option is longevity protection—you can’t outlive the income.

The main disadvantage is that if you die early, the payments stop—there’s no income for a surviving spouse and no inheritance for heirs.

A $1,500 monthly payment, with no annual increases (called COLAs, more on those later), will look like this:

The single life will have the highest monthly payment out of the annuity options. When you add other features to the benefit, the monthly payment will decrease.

Joint-and-Survivor

This is the next most common option available, and the law requires this option to be offered to any participants who are married.

The joint-and-survivor payout will pay a monthly benefit to the participant for a slightly reduced amount, but when the participant dies, a payment will continue to the surviving spouse.

Several joint-and-survivor options may be available, for example:

• Joint-and-survivor 100%
• Joint-and-survivor 75%
• Joint-and-survivor 50%

The percentage is the amount of the original payment that goes to the survivor. So if the original payment is $1000, under a 100% joint-and-survivor, all of the payment will go to the surviving spouse after the participant dies. Whereas, a 50% option will send $500 per month to the surviving spouse upon the death of the original participant.

The higher the percentage, the lower the monthly benefit will be to the participant.

Let’s look at an example of a joint-and-survivor 75% option. If your single-life benefit was $1,500, your monthly payment under the joint-and-survivor 75% will be about $1,275 (depending on age), and when you die, your spouse will receive $956 per month.

Here’s what the joint-and-survivor 75% option looks like:

The reduced monthly payment is the major drawback of the joint-and-survivor option, but the continued payments to the spouse can be indispensable.

For married individuals, the joint-and-survivor option is often best.

Period Certain

The period certain option guarantees the payment for a period of years in exchange for a slightly reduced monthly benefit.

With a 10-year period certain option, even if you die in year two, payments will continue for another eight years to your chosen beneficiary.

This option provides some protection against the risk of dying early and ending benefits without reducing the payment as much as a joint-and-survivor.

If the single life benefit is $1,500, a 10-year period certain benefit might be about $1,455, depending on age.

Here’s what it looks like:

Social Security Leveling

This option is for those who want to retire early (between the ages of 55 and 62).

Some pensions allow you to retire early but still have a consistent income through retirement. They will give you an increased monthly payment for a number of years until you start Social Security, and then the pension payment will drop down, but the total income will stay the same after Social Security is factored in.

The new lower payment, combined with the Social Security benefit, will equal the same amount as the payment you had before.

For example, let’s say you retire at 55 and want to start Social Security at 62. If your regular pension amount were $1,500, and your Social Security benefits were $2,000, then your pension would start at $2,738 per month from ages 55 to 62, and then it would drop down to $738 per month after age 62.

This levels your income from pension and Social Security to $2,738 per month throughout retirement.

Lump Sum

Sometimes employers offer the ability for the employee to take their pension as a single lump sum instead of a stream of annuity payments.

They use an actuarial calculation to determine the amount of the lump sum, based on your age, life expectancy, and return assumptions used in their pension document.

The lump sum will be actuarially equivalent to the single life payment. That just means that if you live according to your life expectancy and meet the return assumptions, then the lump sum and single life payment will come out exactly the same.

If your monthly benefit is $1,500, and you are age 65, then you can expect a lump sum of about $250,000, depending on several factors.

Hybrid Pension Options

Often called a “pull-ahead” or a “DROP,” hybrid options pay a lump sum benefit up front when you retire, and then pay a reduced benefit for life afterward.

A DROP option can also allow the employee to continue working after receiving the lump sum without increasing the pension payout.

Having joint-and-survivor options available on the pull-ahead or DROP is also common.

Let’s look at a 3-year pull-ahead option for someone with a $1,500 single life benefit. The lump sum payment will be $54,000 ($1500 times 3 years of payments). The reduced monthly benefit will be $1,125.

When Can You Receive Pension Benefits?

Full benefits are payable at normal retirement age.

The specific plan must define what normal retirement age is, but the law requires it can’t be later than age 65. For most plans, it’s between ages 62–65.

For many plans, you cannot start receiving benefits until you obtain the normal retirement age.

However, some plans include an early retirement provision. A typical early retirement provision would be age 55 and at least 10 years of service. If you meet those requirements, you can start receiving benefits, albeit at a reduced amount.

Pension Vesting

Employers can restrict how long you must work at the company before you are eligible for the pension.

If the company withholds money from your paycheck toward your pension, then you are always 100% vested in that amount because it was your money to begin with.

But your employer can subject to a vesting schedule any money they put into your pension on your behalf.

The IRS sets maximum limits on how long a company can wait before vesting your benefit. There are two different vesting schedules: five-year cliff and seven-year graduated.

Pension-Benefit Calculations

Pensions have different formulas for how they calculate your benefit, but they almost always involve three things:

1. Salary
2. Years of service
3. Accrual Factor

The formula usually multiplies each of these to get your yearly benefit:

(Salary) * (Years of service) * (Accrual factor) = yearly benefit

Then divide by 12 for your monthly benefit.

Make sure you understand how your pension counts all three factors and how they affect your benefit because this affects when and how you should retire and start your pension.

How Salary Affects Pension Benefits

Pensions have different ways they will count your salary.

Some common ways pensions factor in salary:

• Average of three highest years of compensation
• Average of final three years of compensation
• Average of five highest consecutive years compensation

The different formulas can affect when and how you might retire.

If your benefit is based on final compensation, that means it’s an average of your salary during the last years you worked at the company. Under final compensation, you probably don’t want to scale back hours before retiring. It’s best to retire all at once because a couple lower years of income before retirement will reduce the benefit.

But if the benefit formula instead is highest years compensation, then you can cut back toward the end of your career without affecting your benefit because the formula will only look at the five highest years in the calculation, no matter when they occurred.

Finally, if the formula includes the highest consecutive years, they will look at the three highest salary years in a row. In this case, you’ll want to analyze what those years are. If they are the most recent four years, and you received a nice raise three years ago, working one more year might increase your benefit.

How Years of Service Affect Pension Benefits

In a standard pension, the longer you work at the company, the larger your monthly retirement benefit will be.

Most pensions have a cap on how many years of service will factor into the formula, and it’s usually between 25 and 35 years. Military pensions are one of the few that have no cap on years of service.

You should understand where the cap is on your years of service and how working additional years will affect your benefit.

Accrual Factor

The accrual factor is a percent that adjusts how much your monthly pension benefit will be.

The accrual factor is usually around 1–2%.

It’s best to see how this works in practice.

Here’s a common formula: (Average three-years highest consecutive compensation) * (years of service up to 30) * 1.5%

1.5% is the accrual factor in this case.

Let’s say the average of your highest three years of consecutive pay came out to $50,000 and you worked at the company for thirty years.

$50,000 * 30 * 1.5% = $22,500

Your annual pension benefit is $22,500. Divide by 12 to get your monthly benefit: $1,875.

If, instead, the accrual factor was 2%, it would look like this:

$50,000 * 30 * 2% = $30,000

For a monthly benefit of: $2,500.

So you can see how a small adjustment in the accrual factor can have a big impact on your retirement benefit.

Having breakpoints on the accrual factor is common. For example, it might start out at 1%, and then after 15 years of service it jumps to 1.5%, and then after 25 years of service it jumps to 2%.

If you have a pension with breakpoints in the accrual factor, make sure you understand them because working a couple extra years can have a huge impact on your benefit.

COLA (Cost-of-Living Adjustment)

A COLA is an annual increase in your pension benefits.

Social Security benefits have a COLA, and the COLA on pensions works in the same way.

Most private pensions do not have COLAs, while most government pensions do. But be sure to find out if your pension has one.

The increase can either be flat, such as 2% every year, or it can be variable, based on another rate, such as the CPI.

COLAs are a powerful benefit because even a small annual increase can make an immense difference in your retirement security.

Inflation is one of the biggest risks against your retirement assets, and COLAs help protect you from inflation. With 2% increases per year, a $1,500 benefit becomes $2,200 in 20 years. This also helps offset the cost of nursing homes in the future if they are needed.

A joint-and-survivor option with a COLA (using the same benefits as the joint-and-survivor earlier) looks like this:

Comparing Lump Sum vs. Monthly Pension

When deciding how to take your pension, if there is a lump sum option available to you, the first step is to compare the lump sum with the monthly payment.

To do this, you need to find the rate of return you would need on the lump sum in order to generate the same cash flow as your pension payment.

Let’s use a simple example to illustrate. If the lump sum were $120,000 and your pension paid you $1,000 per month for 10 years, the rate of return would be zero.

($1,000 per month) * (12 months) * (10 years) = $120,000

You don’t need any return on your money to generate that cash flow. You could stick the money in a safe and still make the payments over 10 years.

In this case, the pension is a terrible deal. You would even be better off taking the lump sum and putting it in a CD, let alone what you would expect to get in a diversified portfolio.

But if the lump sum were $120,000 and the pension paid $1,500 per month, that would come out to an 8% return per year. That means if you took the lump sum, you would need to earn 8% on your money per year to equal the same cash flow as the pension.

An 8% return for the pension is a pretty good deal, all other things being equal.

The question is: Can you earn 8% on your money per year with no risk? While some insurance products may claim you can, the answer is no. You might be able to get a higher return, but not without risk.

To make this calculation, use a calculator that can solve for rate of return.

1. Use the lump sum as the present value.
2. .Use the monthly pension payment for the payment
   • Make the payment negative because it’s a cash outflow.
   • Multiply payment by 12 to make it annual.
3. Use your life expectancy for the number of years.

You’ll need to make some assumptions on the life expectancy, but the Social Security tables are a good start.

If you don’t have a calculator handy and you don’t want to figure out your life expectancy, we have an easy calculator here.

Finally, you must factor in whether or not your pension has a COLA.

Without a COLA, it’s more of a one-to-one comparison. How comfortable are you with the return? A high return probably means you should take the pension, while a low return favors the lump sum.

With a COLA, however, the comparison is a bit more complicated, but you’ll almost always want to go with the pension if it has a COLA.

Is Your Pension Secure?

Analyzing the options and choosing the best one is great, but what if your company goes out of business next year? What happens to your pension?

The security of your pension depends on the category your pension falls under. There are three main categories of pension in terms of security:

1. Federal
2. Private
3. State/local

Federal pensions are backed by the federal government and are therefore the most secure.

The government can’t technically run out of money because they can always print more. And if something happens to the federal government so that they can’t pay out their pensions, it’s likely that all other pensions have collapsed as well.

The Pension Benefit Guaranty Corporation (PBGC) backs most private pensions.

The PBGC is insurance that corporations are required by law to purchase for their pensions. If the company goes out of business, the PBGC covers the pension payments up to $67,000 per year for those starting benefits at 65. But the actual amount per plan varies depending on when the plan closed and the age you start benefits.

The PBGC does not cover pensions with less than 25 participants or pensions of religious organizations.

State and local pensions are backed by the state or municipality that governs them, and are not covered by the PBGC or backed directly by the federal government, and are therefore the most at risk.

Plans sponsored by municipalities are more at risk because they can file bankruptcy. If this happens, retirement benefits will be among the first creditors in line, and will likely receive reduced lump sums as payment.

States, however, cannot file bankruptcy, and it’s less clear how they could solve the issue of underfunding. In the case of a severely underfunded state pension, they will have to reduce benefits unless the federal government bails them out.

If you have a state or local pension, be sure to keep an eye on their funding status.

The When and How of Your Pension

How do you decide when (what age) and how (what payout option) to take your pension?

People often pick the option with the highest payment, even though they don’t understand all the options available and how they affect the overall retirement plan.

But choosing the default option or the highest option is usually a mistake.

Each option has its pros and cons.

Lump sum payouts can be subject to investment risks, assuming that you do invest it and don’t buy a Ferrari. Monthly payout options are subject to inflation risk, especially if there is no cost-of-living adjustment (COLA). And finally, single life monthly payouts can leave your spouse without that income stream if you die prematurely, while joint-and-survivor options reduce your immediate income.

You must take into account several factors when deciding on your pension:

• Retirement income sources
• Desired retirement date
• Legacy goals

The more retirement income sources you have, the more flexibility you have. You may decide the flexibility the lump sum offers is valuable to you, or instead the longevity protection of the pension payments is more beneficial. But with less income sources, you have less flexibility and should look for the option that will maximize your success in retirement.

If you desire an early retirement, you must create a more specific strategy. In this case, be sure to know the breakpoints in your pension. Additionally, you may be able to retire early but delay the start date of the pension for a higher benefit. But be sure to know if your assets can sustain you in the interim.

If you have a legacy goal to leave a large inheritance or a lump sum to charity, you might consider the lump sum option on the pension—depending on the rate of return calculation. But if you would prefer to spend as much as possible while you are alive, then you might opt for the monthly pension—again, depending on the rate of return calculation.

Go through these ten key questions to help make the pension payout decision:

1. Do you have a lump sum available?
2. What is the return on the lump sum?
3. Does the pension have a COLA?
4. Are you married?
5. What will happen to your spouse if you die and your pension goes with you?
6. How much retirement income do you need, and how well do other income sources cover that need?
7. Do you want to continue working at this job as long as you can, or do you want to retire early?
8. How is your benefit affected by retiring early?
9. Do you have sufficient assets to sustain an early retirement?
10. Where do you want to leave your money when you die?

The choice is unique to every situation.

You should consult with a financial advisor who is familiar with your overall situation and financial plan. Software allows us to run scenarios with any option and stress-test them to see how each one will affect your chances of success in retirement.

There are many creative ideas around selecting the right option for you and your family, so don’t overlook this aspect of your retirement plan.

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*Advisory services offered through Paul Winkler, Inc. (‘PWI’), an investment advisor registered with the State of Tennessee. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.