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Personal Finance

What Is a Pension Fund?

A pension fund, or pension plan, is set up by an employer, labor union or another organization to pool and invest money to be used for future employee retirement benefits. In the U.S., 401(k)s and individual retirement accounts (IRAs) have edged out pensions as a primary vehicle for retirement savings. Pension funds still exist, however, and taking advantage of one if it's available can be a great way to set yourself up for retirement.

How Does a Pension Fund Work?

A pension fund is what's known as a defined-benefit plan. This means an employee will receive pension benefits in retirement that make up a certain percentage of the annual salary they earned while working. A pension fund may be limited to one or several employers, or may have no restrictions on membership.

Sponsors of pension plans include Fortune 500 companies; federal, state and local government agencies; and school systems. Generally, employers contribute most of the money toward pension benefits. However, some plans require employee contributions, and others make employee contributions voluntary.

Pension contributions are invested in stocks, bonds, commercial real estate and even portfolios of student loan debt or credit card debt. While you lack control over how a pension fund invests money, you will receive the same monthly pension payment for the rest of your life, regardless of how the fund's investments perform.

Like other methods of saving for retirement, pensions have their pros and cons, and promoters and detractors. According to the AARP National Retired Teachers Association, the "traditional and best approach" to retirement security comprises pension and Social Security benefits, along with individual savings.

However, critics argue that some pensions are drastically underfunded and sometimes make risky investments. In some cases, the federal government ends up bailing out failed pension funds. Furthermore, some businesses in recent years have closed or frozen their traditional pension plans, which tend to be complicated and costly to operate.

Take all factors into consideration when planning your retirement and go with the method you think would work best for you. You may find yourself agreeing with the AARP and including a pension as part of your retirement strategy alongside other methods, such as a Roth IRA.

When Can I Withdraw From My Pension Fund?

If you have a pension, you typically can't obtain full benefits until you reach a certain age, like 62 or 65. But if you retire early—at age 55 or 60, for example—you may be able to receive a lower monthly pension payment. And if you're terminated by your employer, you still may qualify for a reduced pension payment, depending on your age.

And if you leave your job before you're able to draw from it, you unfortunately may not be able to take money out of the pension plan or take your pension with you when you leave your job. Leaving with some or all of your money will depend on whether your contributions have vested, meaning they're entirely yours, and what the pension plan's rules are.

Some pension plans may let you borrow against your pension, although this is something financial experts say is unwise. So-called pension advances provide a lump-sum payment you'll pay back by signing over your pension checks to a private lender over a period usually lasting five to 10 years. The fees attached to pension advances can effectively raise the annual percentage rate (APR) for this borrowing method to more than 100%, making it an unattractive way to raise cash.

What Is the Difference Between a Pension Fund and a 401k?

Both a pension fund and an employer-provided 401(k) enable you to save money for retirement, but they differ in a few key ways.

A pension plan promises a certain monthly benefit when you retire. It may be several hundred dollars a month or, more often, it involves a formula that takes into account your salary and length of employment. Normally, pension plans are protected by federal insurance.

Among the advantages of a pension fund are:

  • Hefty benefits can be built up over a short period, even if you take early retirement.
  • Employers can contribute more than they can under other types of retirement plans.
  • Benefits are insured.
  • The amount of benefits doesn't depend on how the fund's assets perform.

Disadvantages of a pension fund include:

  • Choosing a benefit for your survivors will cut into your monthly benefits while you're alive.
  • If a retiree is single when they die, the pension benefit can't be inherited by the retiree's heirs.
  • Unlike a 401(k), you can't withdraw a lump sum from your pension to cover expenses such as medical costs or a child's college tuition without a pension advance.
  • Monthly pension benefits can stay flat over time, without any adjustment for inflation.

By contrast, an employer-sponsored 401(k) does not promise a set amount of money per month. You and your employer can make tax-deferred contributions to a 401(k), which—coupled with investment gains and losses—will dictate how much money the account ultimately contains by the time you retire. Investments in 401(k) accounts, such as stocks, bonds and mutual funds, are not federally insured.

Among the advantages of a 401(k) are:

  • You're in the driver's seat when it comes to 401(k) contributions. You can chip in as little or as much as you'd like.
  • When you leave a job, you retain ownership of a 401(k).
  • Contributions to a 401(k) come out of your paycheck before federal taxes are withheld. You don't pay taxes on the money until you withdraw cash from your 401(k).
  • Many employers match part of your contributions up to a certain percentage of your annual pay.

Disadvantages of a 401(k) include:

  • Management fees can eat into your investment gains.
  • You may be penalized for withdrawing money before age 59½.
  • You may have little control over the quality and quantity of investments.
  • Monitoring your 401(k) investments may require a fair amount of work on your part.

What Should I Do if My Employer Doesn't Offer a Pension Fund?

If your employer doesn't offer a pension fund, you've got some alternatives. Your options include:

  • Employer-sponsored 401(k)
  • Traditional IRA: This type of IRA lets you set aside tax-deferred money for retirement. With this setup, you can claim tax deductions on your contributions. You pay taxes on the money in your account when you withdraw it.
  • Roth IRA: Money you put into a Roth IRA already has been taxed. This means you won't pay any taxes on money when you withdraw it. Unlike a traditional IRA, you can't claim tax deductions on contributions to a Roth IRA.

A number of financial institutions offer IRAs, such as banks, credit unions, investment brokerage firms and mutual fund providers. Rather than setting up an IRA through an employer, you'll need to establish it and maintain it on your own.

The Bottom Line

Regardless of whether you'll be relying on pension benefits in retirement, it's wise to create a retirement plan. Your plan should include deciding how you'll save for retirement (if you haven't done so already), regularly checking your Social Security statement, watching expenses so you'll have more money for retirement and consistently monitoring your credit.