All good parties must come to an end, and this one is no exception. The old geezers of the group, grandma and grandpa Pension, are complaining that the music is too loud and that it’s past their bed time. They have however agreed to do one last meet and greet before this shindig wraps up. So without further ado it is my pleasure to introduce you to Mr. & Mrs. Pension (they are cranky so we will keep this short).
So what is it? Pensions are company sponsored retirement plans that provide retired employees with a fixed payout, usually paid monthly, for the remainder of their life. A common requirement is that the employee work for the sponsoring company for a specific period of time determined by the company (this is referred to as vesting) in order to qualify for the pension benefit.
How does it work? The employee first must sign up for the pension plan then complete a vesting period, usually 5-7 years of active employment, once complete they are entitled to a fixed benefit in retirement (age 65). The amount paid is usually determined by number of years worked for the company and salary level upon retirement or throughout the employee’s career. Traditionally pension plans do not require employee contributions, the employer provides all the funding, however there are some plans that may require employees to contribute.
- Example: Sam worked for Procter & Gamble for 30 years; his Pension plan states that he will be paid 2% of his average salary multiplied by the number of years worked for the company, each year once he retires. Sam’s average salary during his employment was $70k per year. To calculate his pension payment Sam multiplies 2% by his average salary ($70k) then multiplies the result by years worked (30) to get $42k (2% x $70k x 30). The result, once Sam retires he will receive $42k a year in pension benefits, or if paid monthly $3,500 a month for the rest of his life (pretty sweet deal in my opinion).
Important information to note: Over the past few decades pension plans have become scarcer, especially in the private sector mainly because of the high cost to maintain. With no employee contribution in many cases, and guaranteed befits, the employer must offset any market downturns to maintain the fixed benefits. It should be no surprise that direct contribution plans like the 401(k) have become the retirement vehicle of choice due to lower costs and the ability to pass the responsibility for retirement planning on to the individual employee.
So that about wraps it up for this retirement party, if you have any additional questions about pensions drop a comment below and I’m sure we can convince Mr. or Mrs. Pension to get back to you. If you missed all the action until now you can catch up here with the 401(k) and here with the IRA.
I hear there is an after party in the works for sometime next week, make sure to tell your friends (I hear Facebook, Twitter, and Google+ are good ways to do that ;)) so they can catch up on all the action before it happens!
 This is a very simple example; the math behind the real calculations can be much more complex.