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Traditional Pensions

A traditional pension is also known as a defined benefit pension plan. This is the type of pension plan that your father or grandfather probably had. Your employer puts money aside for you, manages it, and guarantees you a specific amount of money for life upon your retirement. The total amount of your pension depends on how long you have worked for the company and how much money you've earned over the years.

How They Work

Pension plans usually begin paying you benefits when you reach retirement age and stop working. Benefits will continue for as long as you live. Most defined benefit plans send you a monthly check. Some give you the option, instead, to receive one lump-sum payment when you retire.

  • Vesting --In most defined benefit plans, you must participate for a certain number of years before you have a legal right to receive the benefits. This is called "vesting."
  • You, or your spouse too? -- When you join a defined benefit plan, you must decide whether your pension will cover you alone, or you and your spouse. If you choose the second option, your spouse can continue to receive your pension checks after you die. If you decide to have your pension cover only you, you'll receive more money in each month's pension check. Your spouse must agree in writing to this arrangement.
  • Social Security's impact -- Some defined benefit plans work hand-in-hand with Social Security benefits. Because employers contribute money in your name to the Social Security system, the law allows them to reduce your pension benefit by up to 50% of your projected Social Security benefit. If you decide to retire early, most plans will give you additional money until you become eligible for Social Security.
  • Safety -- The Pension Benefit Guaranty Corporation (PBGC), a government agency, protects and insures pensions. If your plan doesn't have enough money to pay your benefits, the PBGC will pay the benefits up to a certain point. You may not get the full pension that you expected.

Cash Balance Plans

More employers are offering or converting their pension plans to cash balance plans. A cash balance plan is a defined benefit plan. With a cash balance plan, your employer deposits a pay credit and an interest credit in your account each year. The pay credit is dependent upon your salary.

A cash balance plan considerers just one thing—your salary. The length of your employment or your age has no bearing on the plan. There are no investment decisions to make, an employee doesn't make contributions, and when you retire, you receive your money as a lump sum or an annuity. If you are vested and leave your job, often you can receive the annuity prior to retirement age. Investment risks and rewards on plan assets are borne solely by the employer.

Cash balance plans can be beneficial for younger employees. That's because benefits are not based on the length of your employment and age. Cash balance plans are less attractive to mature workers for the same reason—age and longevity on the job are not rewarded.

Action Steps

This article is meant to provide general financial information; it is not meant to substitute for, or to supersede, professional or legal advice.

Note: The content areas in this material are believed to be current as of this printing, but, over time, legislative and regulatory changes, as well as new developments, may date this material.

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