Pensions Explained: Defined Benefit Plans, Lump Sums and Annuity Payments

Pensions are less common than they used to be, especially in the private sector, but millions of workers still have them, particularly in government, teaching, public safety and some unionized jobs. If you’re one of them, understanding your pension can shape your entire retirement plan. Your pension choices can affect your income for the rest of your life and potentially your spouse’s, so it’s worth taking the time to understand your options.

Defined benefit versus defined contribution

A traditional pension is a defined benefit plan. It promises a specific income in retirement, usually based on a formula that considers your salary and years of service. For example, a formula might multiply a percentage by your years of service and your average salary over your highest-earning years. The employer is responsible for funding the plan and managing investments, and it bears the investment risk.

A 401(k), 403(b) or similar plan is a defined contribution plan. What you get depends on how much you and your employer contribute and how your investments perform. You bear the investment risk and make investment decisions.

The key difference is who bears the risk. With a pension, the employer promises a specific benefit. With a defined contribution plan, your retirement income depends on your savings and investment results.

Understanding your pension

Start by learning the details of your plan. Your plan’s summary plan description explains how benefits are calculated, when you can start receiving them and what options are available. Many plans also provide annual benefit statements estimating your future benefit.

Key terms to understand include vesting, which determines when you have a right to receive benefits, typically after a certain number of years of service. Normal retirement age is when you can receive your full benefit, while early retirement options may let you start benefits sooner, usually with a reduction. Some public pensions also include cost-of-living adjustments that increase benefits over time.

Common payout choices

When you retire, you’ll typically choose how to receive your pension. Common options include a single-life annuity, which provides monthly payments for your lifetime. Payments stop when you die, with nothing continuing to a spouse. This option usually provides the highest monthly payment.

A joint-and-survivor annuity provides monthly payments for your lifetime, and after you die, payments continue to your spouse or another beneficiary, often at a reduced amount, such as 50%, 75% or 100% of your benefit. Because payments may continue for two lifetimes, the monthly amount is often smaller than a single-life annuity.

A lump sum is a one-time payment of the value of your pension, which you can roll into an IRA to keep tax advantages, if your plan offers it. Not all plans offer lump sums, and public pensions often don’t.

Some plans offer other options, such as period-certain annuities that guarantee payments for a minimum number of years.

Married workers generally need their spouse’s written consent to choose a payout that doesn’t include survivor benefits under federal rules for private-sector plans. This protects spouses who might otherwise lose income after the worker’s death.

Lump sum or monthly payments?

Choosing between a lump sum and monthly payments is one of the biggest pension decisions.

Monthly payments offer guaranteed income for life, which protects you from outliving your money and from market swings. You don’t have to manage investments or worry about how long your savings will last. For many retirees, guaranteed income provides valuable peace of mind.

A lump sum offers control and flexibility. You can invest the money as you choose, access it for large expenses and leave remaining funds to heirs. However, you take on investment risk and must make the money last for the rest of your life, which requires discipline and careful planning.

Factors to consider include your health and life expectancy, your other sources of income, such as Social Security and savings, your spending needs, your comfort with investing, whether your pension includes cost-of-living adjustments, the financial health of the pension plan and your desire to leave money to heirs.

Comparing the lump sum with the cost of buying an equivalent annuity from an insurance company can help you evaluate whether the lump sum is a good value.

Is your pension protected?

Many private-sector pensions are insured by the Pension Benefit Guaranty Corporation, or PBGC, a federal agency. If a covered private pension plan fails, the PBGC pays benefits up to legal limits, which depend on your age and the type of benefit.

Government pensions are generally not covered by the PBGC. Instead, they’re backed by the government entity that sponsors them, such as a state or city. Their financial health varies, and some public pension plans face funding challenges.

Coordinate with Social Security

Your pension is part of your overall retirement income plan. Coordinate your pension decisions with Social Security claiming strategies and withdrawals from savings to create a comprehensive plan.

Get help

Pension decisions are often permanent and can have major financial consequences. Consider talking with a fee-only fiduciary financial planner, who is required to act in your best interest, before choosing. Your plan administrator can also answer questions about your benefits and options.