Pensions • September 18th, 2020

What is a Corporate Pension Plan and How Does It Work?

Michael Schultheiss

Key Takeaways
  • Corporate pension plans provide income based on your length of service with the company and your salary history.
  • Defined-benefit corporate pension plans provide a specified benefit amount over the course of your lifetime.
  • Defined-contribution plans are funded by a specified contribution amount, with the proceeds invested and the return on investment (ROI) credited or debited to you.

Corporate pension plans can be an excellent source of retirement income for those employees, in either the private or public sector, who qualify for them. There are two main kinds of corporate pension plans, defined-benefit and defined-contribution plans. The former is the older type, and it is increasingly being replaced by defined-contribution plans and by other types of retirement plan.

If you have a corporate pension plan or are considering taking a job that offers one, it is a good idea to speak with a Certified Financial Planner® to ascertain what your financial options are. A Certified Financial Planner® can help you to get a clear picture of your financial situation in retirement.

What is a Corporate Pension Plan?

Corporate pension plans are benefits that provide income during retirement on the basis of how long the employee has been employed by the company, as well as their salary history.

Qualifying for a corporate pension plan typically requires one to work for the company for a minimum period of years, a so-called “vesting period,” with vesting defined as the amount of pension plan proceeds that you are entitled to based on how long you have worked for the company. Vesting periods are highly variable and form a significant part of the pension plan process.

Some pension plans vest right away, while others are spread out over a longer period, typically up to seven years. It is important to be aware of vesting timetables and schedules, because they impact whether or not you will be eligible for a full or a partial pension. If you are seeking to change jobs, consider vesting options. A Certified Financial Planner® can help you make sense of your options.

These pension plans have now become relatively rare in the private sector, with the 401(k) and other plans replacing them. As of 2019, 13% of private-sector employees had corporate pension plans.

Corporate pension plans are much more common in the public sector. In 2019, 83% of state and local government workers who participated in workplace retirement programs had corporate pension plans.

Main Types of Corporate Pension Plans

There are two main types of corporate pension plans: defined-benefit pension plans and defined-contribution plans. The first is the more traditional type of corporate pension, while the latter represents a more recent innovation that has gained ground widely in recent times.

Defined-Benefit Plans

With a defined-benefit plan, paying into a pension fund is conceptually simple: your employer commits to paying a specific amount, over the course of your lifetime. Crucially, the employer calculates this amount ahead of time, before your retirement. They use a formula based on your own age, the length of your service with the company, and your salary at retirement.

How much can a company contribute to a pension? The United States has a maximum permitted retirement benefit of $230,000 in 2020, compared with $225,000 in 2019. This maximum benefit is subject to cost-of-living adjustments (COLA) in future years.

Both employers and employees can contribute to defined-benefit plans. Companies that offer these plans have pension funds from which the defined pension benefits are paid.

Defined-benefit plans are the original corporate pensions plans. However, over time they have declined because corporations want to assume less of the investment risk and have been increasingly replaced either by other types of retirement plan, or by defined-contribution plans.

Defined-Contribution Plans

With defined-contribution plans, you are guaranteed a set contribution rather than a set benefit. The contributions may be paid by you the employee, by your employer, or both. Whatever the source, the contributions are invested, and the returns on investment (ROI) are credited to or debited from your account depending on the gains or losses, respectively.

The thrift savings plan (TSP) is the most well-known defined-contribution plan in the United States. This plan is open to federal employees and to military service members.

Once you retire, your account will start paying out your retirement benefit. This is typically done by means of an annuity, though the amount will fluctuate based on the value of your account.

Because investment is one of the key features of this pension scheme, the amount that you will get out of it will depend on how well the investments do. Paying into a pension fund is only a part of how these pension types work.

These defined-contribution plans have become widespread throughout the world in recent years, such that they are now the most important form of retirement plan in many countries outside of the United States. The United States has also seen increasing numbers of these plans, for the simple reason that they are more affordable than the defined-benefit plans.

Are Corporate Pension Plans Taxable?

The majority of pension plans are taxable, and it is therefore important to understand your tax liability on your pension plan. Depending on what your options are, you may want to talk to your employer and to a Certified Financial Planner® to ascertain whether it is better to have the taxes taken out of your pension plan payments in retirement as opposed to before.

If after-tax funds were contributed to your pension, some portion of your pension proceeds may be tax-free – but it is vital to get your employer or a professional tax accountant to clarify that. Additionally, employees with disabilities sometimes have taxes waived on their pension plan proceeds in retirement, though it is important to have this clarified as well.

Bottom Line

Corporate pension plans can be a useful source of retirement income. It is important to be clear ahead of time, before you retire, how much you will qualify for. With the rise of defined-contribution plans, it is increasingly important to understand where your pension funds will be invested and what return on investment you should reasonably expect.

Whatever your situation, a Certified Financial Planner® can help you to make sense of it and get the clearest possible perspective on your finances in retirement.

Author

Michael Schultheiss

Michael Schultheiss is a freelance copywriter of long-form content and other marketing communications (B2B and B2C) in the financial services and FinTech niches. In copywriting, he looks for hungry crowds. Other interests include health, fitness, and reading and writing fiction.