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Pensions are retirement accounts with a guaranteed benefit. Bankrate explains.

What is a pension?

A pension is a retirement fund for an employee paid into by the employer, employee, or both, with the employer usually covering the largest percentage of contributions. When the employee retires, she’s paid in an annuity calculated by the terms of the pension. Pension funds are far less common than they used to be, with labor unions and public employees making up the vast majority of pension holders.

Deeper definition

Pensions are paid as an annuity, meaning over a regular, fixed period, to retired employees of an organization as compensation for past employment with that organization.

The two most common pension types are called a defined-benefit plan and a defined-contribution plan. Both plans are paid out in retirement, but they differ in the formulas used to define contributions and payouts upon retirement.

Defined-benefit plan
Defined-benefit plans are calculated with a formula considering the employee’s salary, the years she worked for the organization, and a multiplier set by the organization. Unlike defined-contribution plans, the employee is guaranteed an amount, which is set by the formula when the employee becomes a pension member. Defined-benefit plans can be unfunded, meaning that benefits are paid for by the employer as they’re paid out; or funded, meaning that employers invest contributions in a fund that is paid out later.

One of the simplest formulas in use takes the monthly contribution, multiplies it the years the employee worked for the company, and pays out that dollar amount monthly after she retires. Social Security is a type of funded defined-benefit plan sponsored by the federal government into which beneficiaries pay a percentage of each paycheck as long as they’re employed.

Defined-contribution plan
Money contributed to a defined-contribution plan can either come out of the pension member’s salary or from contributions made by her employer. Unlike defined-benefit plans, defined-contribution plans don’t promise a guaranteed benefit. In that sense, they’re not truly pension funds, because contributions to the worker’s pension are placed in an investment account and the annuity is tied to the health of the investment. A 401(k) account is a common type of defined-contribution plan.

Pensions can become underfunded when the money paid into it is less than the amount owed to pensioners. In some cases, like when the employer dips into the pension fund to pay for operations, misuse of funds can cause the reduction or complete depletion of pension accounts. This occasionally happens to retired government employees when pension funds are used to pay for public works.

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Pension example

Manufacturing used to be one of the bedrocks of the American economy, employing millions of people over time. Many of these workers were part of labor unions and were promised pensions after they retired. However, advances in technology and generous free-trade agreements significantly reduced the workforce. As workers retire, however, and no new ones are brought on to take their place, the pension funds they rely on to live off of in retirement are starting to dwindle.

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