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How Do Pensions Work?

Do you receiving a pension? Are you paying into one? If so, do you know how they work?

how pensions work

What Is It?

A pension is what is called a defined benefit plan, meaning the benefits to you are defined. The benefits are defined no matter what happens in the markets.  This used to be how the majority of us were able to retire in the past. Over time companies have grown to offer what are known as defined contributions plans instead (403(b), 401(k), etc.). That is, your contributions are defined - usually as a percentage of your paycheck, but your benefit depends on what the investment markets do between now and when you need the money. 

So essentially you pay in with each paycheck and the company usually matches a portion of it. Then at retirement you get monthly paychecks for the rest of your life. It's important to note that with pensions, the investment risk lies with the company and not with you. 

Comparison To Social Security And Annuities

You may have read that and thought to yourself that these sound a lot like Social Security or an plain annuity. Congratulations! The underlying system is the same. Social Security is effectively a government-fun pension plan. Annuities offer the same benefit in the you can pay some money each month and get paychecks each month when you retire (alternatively, you can pay a lump sum in exchange for monthly paychecks). All three of these systems offer similar payout options and they all offer payments for your life. 

Options Exist, But You Get a Smaller Check

If you want payments to last longer than just your life, or if you want to make sure your payments last a certain amount of time or so that you at least get your deposits back, you can usually do that. To do that, though, will cost you money in the form of smaller monthly paychecks.

For example, if someone with a pension chooses the main option, the paychecks stop after that person dies. That means that if the surviving spouse lives longer, though, there is no income for that spouse. By choosing the option where the paychecks last until the second spouse dies, you make sure there is income for both of your lives. The trade-off, of course, is that the monthly paycheck will be lower. That makes sense because your household may be getting more paychecks over time. 

As with anything, you have to make sure any option you choose works for you and your situation. Consider this situation: if you have a family history of living a long time and choose the option to guarantee your payments for 10 years, you get a smaller paycheck for the rest of your life. You were likely going to live that long anyway so you just effectively lowered your payments. Now, just because that's the math doesn't mean it's necessarily right. If you would be worried about dying too early and not getting 10 years worth of payments, then it may be the right thing to do. The smaller check is how much it costs for peace of mind. 

The Math Department Determines Your Paycheck

All these payment amounts, formulas, and options are determined by what I call the math machine. This math department is filled with people called actuaries who basically do calculus for a living. The idea is that these options and prices are set so that it doesn't matter which option you choose. There are enough people in the pension system that on average all the options are identical. What means is that, on average, someone to takes the plain vanilla, first to die option will get a higher paycheck, but for a shorter amount of time. If the same person takes the second to die option so the paychecks will continue until the second spouse dies, then they get a smaller check but over a longer period of time. On average both of those total amounts will be the same. 

And it doesn't much matter if you live longer than expected because with enough people in the pool, for everyone who lives longer than life expectancy, there is someone who lived less than life expectancy. 

Final Thoughts

If you have a pension, you'll have to take some time to figure out the best strategy for you. First, understand that all the options will work out to be the same if you live to average life expectancy. Second understand how likely it is you and your spouse will live longer than that. Third, try to understand how it will feel for your surviving spouse or heirs if you don't live as long as you think. 

Taking the time to determine how a pension fits into your overall financial life is good money health.

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© 2018 Money Health Solutions, LLC



About the Author

Derek Hagen, CFA, CFP, FBS, CFT-I, CIPM is a speaker, writer, and coach specializing in financial psychology, meaning and valued living, resilience, and mindfulness.


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