What is a pension & how does it work?

Pensions may be less common than they once were, but if you're among the millions of people who've earned one, it can contribute a great deal to your income security in retirement. Pensions differ from 401(k)s, IRAs and other retirement savings tools. Understanding how yours works will help you maximize its benefits and incorporate it into your overall financial strategy.

A pension is an employer-sponsored defined benefit plan designed to provide a reliable, often lifelong, source of retirement income. You earn a pension by working in a job that offers it as an employee benefit. Your employer contributes money during your working years and invests those funds to grow in value. If you stay with that employer for a certain amount of time, you'll be eligible to receive payouts when you retire. Often, a pension pays out a guaranteed monthly income stream that can continue through the rest of your life.

A pension plan is a formal agreement that defines the terms of a defined benefit pension. It's the agreement that outlines the rules—how much is contributed, how the money is managed and how its funds are distributed in retirement.

A pension accumulates benefits while you're employed. After you retire, you can take money out. The process occurs in three stages:

1. Contribution. Money is put into an organization's pension fund during your working years. Employer contributions are the main source of traditional pensions, but some allow employee contributions. For example, pension fund contributions from you and your employer may be a set percentage of your gross earnings. Contributions are usually mandatory for the employer and voluntary for employees.
2. Growth. Pension contributions are strategically invested in a diversified portfolio of assets—such as mutual funds, stocks, bonds and real estate—with the goal of growing in value over time.
3. Payout. In retirement, or once you reach an age specified in your pension plan, you can receive payouts. Depending on what the terms allow, you can take the money as a lump sum, a series of individual withdrawals or (most commonly) a stream of guaranteed monthly income payments.

Pensions and other employer-sponsored retirement savings plans generally fall into one of two categories—defined benefit plans or defined contribution plans:

• Defined benefit plan. Your employer contributes to a fund, and you might, too. Your plan guarantees a specific benefit amount, usually distributed as monthly income payments throughout your retirement. Most pensions are defined benefit plans. During the plan's growth stage, your employer manages the fund. You're not responsible for investment decisions.
• Defined contribution plan. You and/or your employer contribute fixed amounts or a percentage of each paycheck to an account. Its growth—and retirement payout—depend on investment performance. You choose how to invest the money. Defined contribution plans include 401(k) and 403(b) plans.

Defined contribution plans, tied to market performance, carry higher risk but offer potential for increased growth and larger payouts compared to defined benefit plans, which provide guaranteed benefits.

Some workplaces offer a cash balance pension, which combines aspects of a traditional pension and a 401(k). Employers contribute to the plan rather than individual retirement accounts. Each year you're on the job, your account is credited with a percentage of your salary, plus interest. You're guaranteed a certain benefit total if you stay with the organization until you retire. The longer you work for the employer, the closer your benefit gets to that amount.

In the past, pensions were more prevalent—in a much broader range of industries—than they are today. Now, 401(k)s and other defined contribution plans are the norm, especially in the private sector. Traditional defined benefit pensions are predominately available through state and local government jobs.

Usually, to receive a pension's retirement benefit, you must become vested. That means you must work a specified length of time for the employer providing your pension. There are two main forms of pension vesting: cliff vesting and graded vesting:

• Cliff vesting. You aren't eligible for any benefit until you reach a certain milestone—for example, three years on the job. After that, no matter when you leave the organization, you're entitled to your full pension when you retire.
• Graded vesting. You become partially vested after a certain period of employment, and the benefit amount you're eligible to receive gradually increases. For example: You might be eligible to receive 20% of your pension benefit after one year on the job, 40% after year two, 60% after year three, and so on, until, at five years, you're fully vested and eligible to receive 100% of your pension benefit.

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Once you're vested, you're eligible to receive your pension benefit when you reach your plan's designated retirement age. Before that date, you can prepare by calculating your pension payout, exploring payout options and considering the potential impacts of taxes and inflation.

Most pensions determine an annual benefit amount using a basic formula:

For example, let's say you had 20 years of service with a final average salary of $80,000 and 2% benefit multiplier. You would have $32,000 of guaranteed lifetime annual income in retirement.

When calculating your accurate pension payout, refer to your plan's specific terms.

Most pension plans let you choose your pension payout form:

• Lump sum. You take one large payment upfront to invest as you wish. Many people roll over their pension's lump sum payout into an IRA.
• Monthly payments. You receive fixed, recurring payouts that continue throughout the rest of your life. You also may have the option to take smaller payments that last through both your and your spouse's lives.

Some pension plans may let you take some of your benefit as a lump sum and some in monthly payments.

Most pensions are funded with pre-tax contributions, so payouts may be subject to federal income tax withholdings. Depending on where you live, you also may owe state income taxes on your pension benefits.

If you take your benefit as a lump sum—and don't roll it over into a traditional IRA—you'll likely owe taxes on the full amount that year. If you opt for monthly payments, you'll only owe taxes on the amount of each payment as it arrives.

If you take withdrawals before you reach your plan's designated retirement age, you'll likely incur an additional tax penalty. There may be exceptions under certain circumstances.

If you intend to take your pension benefit as a lifetime income stream, note whether your plan includes inflation adjustments. If not, your payment amounts won't ever change, which means your purchasing power may decline over time.

Just like other retirement savings plans, pensions have advantages and drawbacks. Recognizing them can help you make informed decisions and achieve financial goals.

• Guaranteed income. Unlike a 401(k) or IRA, a traditional pension poses little financial risk for you. At retirement, you receive a predetermined lump sum or series of fixed payouts.
• Lifelong protection. Opting for monthly payouts can guarantee you don't outlive your savings. Typically, pension benefit payments continue throughout the rest of your life.
• Employer contributions. Usually, the bulk­—often all—of a pension fund's contributions come from the employer. So, you put little or no money in and receive a payout when you retire.
• Minimal management. Before they pay out, pensions are hands-off for most employees. Your employer invests and manages the fund that provides your retirement benefit.

• Limited portability. If you change jobs before you retire, you might not be allowed to move your pension benefit into another retirement savings plan. That differs from many defined contribution plans, such as 401k(s), which usually are more portable.
• Potential for underfunding. Poor investment performance, inadequate contributions and other factors can result in a pension fund balance too low to cover payout obligations. If this happens, your employer might reduce guaranteed benefits for enrollees still working and/or delay or reduce payments to current retirees (a rare occurrence).
• Lack of investment choice. Because your employer manages your pension fund, you have little or no say in how contributions are invested. Alternately, defined contribution plans—such as 401(k)s and 403(b)s—require that you choose how to invest your account assets. That may allow you to pursue higher returns.

Should I contribute to my pension plan?

Your employer is required to contribute, but you may or may not have to. If voluntary employee contributions are allowed, find out how they'll affect your benefit. You might want to boost your pension, or you might prefer to put that money in a separate retirement savings account, such as a traditional or Roth IRA.

Does a pension affect my Social Security benefits?

In most cases, no. Until recently, some people eligible for both Social Security and pension benefits received reduced Social Security payments due to longstanding Social Security Act provisions. However, in January 2025, the Social Security Fairness Act repealed those provisions, halting benefit reductions for many retirees—and, in some cases, their spouses.

What if I leave my pension-eligible job before I retire?

If you're vested in a pension and leave your job, you don't lose your benefit. You might be allowed to cash out with an early lump-sum distribution and roll it into a tax-advantaged account, such as a traditional or Roth IRA. You also might be able to move your pension money into your new employer's retirement plan. Or, you might have to simply wait and take your pension benefit when you reach retirement age.

Can I take my pension early?

You might have that option. But keep in mind that starting payouts before you reach retirement age usually reduces the amount you receive every month for the rest of your life. Taking a reduced lump sum also might be allowed. But, as with most retirement plans, an early withdrawal could incur a costly tax penalty.

What if my employer goes out of business or underfunds my pension?

If your private-sector defined benefit pension is terminated or becomes insolvent, you might receive some or all of your earned benefits through the Pension Benefit Guaranty Corporation, a federal agency. If you're a public-sector pension enrollee, your state provides some degree of benefit protection.

Can I combine a pension with a 401(k) and/or an IRA?

During your career, you might participate in more than one retirement savings plan. For example, you might earn benefits from both a pension and a 401(k). In addition, you may at some point open an IRA. You also might—before or after retirement—roll funds from a pension and/or defined contribution plan into an existing or new IRA.

What happens to my pension when I die?

It depends on what your employer offers. Your plan may include a survivor's benefit for your spouse and/or dependents. Or, you may have named a beneficiary to receive a lump sum or series of payments. It's also possible that upon your death, your guaranteed benefit has been provided and nothing is paid to your heirs.

A pension's guaranteed benefit can form a cornerstone of your retirement income strategy. Whether you've just enrolled, are preparing to retire or have been receiving monthly payouts for a while, consult a Thrivent financial advisor to discuss how your pension supports your overall financial plans.

Government agencies:

• Pension Benefit Guaranty Corporation (PBGC)
• Social Security Administration (SSA)
• Internal Revenue Service (IRS)