Pension vs. Social Security: An Overview
There are many different types of income retired folks draw on, depending on how they spent their working days. Two of the best-known are pensions and Social Security. The two programs are funded and structured in totally different ways.
Pensions are typically workplace retirement plans, in which an employer makes contributions to a pool of funds on behalf of employees. Social Security is handled by the federal government and funded through payroll taxes collected from employees and companies.
Key Takeaways
- Retirement income can be guaranteed through a company’s defined-benefit pension plan and federally funded Social Security.
- These days, fewer companies offer guaranteed pensions. Instead, they offer their workers 401(k) plans, which are self-directed investments designed to generate retirement income.
- Self-employed people have access to Individual Retirement Accounts (IRAs), which they fund on their own.
- Social Security is a government-guaranteed basic income for older Americans, funded through a special tax paid by employees and employers.
- For most retirees without a pension, Social Security will not be enough; other types of retirement savings, like a 401(k) or an IRA, are encouraged.
Pensions
Before the advent of IRAs and 401(k) plans, there were pensions. Your parents and grandparents, if they worked for the same company for many years, may have enjoyed generous pension benefits. Pensions nowadays are known officially as defined-benefit plans because the payment amount you’ll receive in retirement is decided or defined in advance.
A private pension is a retirement account created by an employer for the employees’ future benefit. Employers, governed by certain laws and regulations, contribute on behalf of employees and invest the money as they see fit. Upon retirement, the employee receives monthly payments.
Although they’re becoming rare in the private sector, state government employees frequently have pension systems. For example, in Ohio, state workers pay into the Ohio Public Employees Retirement System in lieu of Social Security.
The private pension payout depends upon a number of factors, such as how long you worked for the employer as well as what your salary was. In some cases, you can choose a lump-sum payment or a monthly annuity check.
In the past, employers were required to maintain excess pension assets within the plan and were not to use the funds for other expenses. This law was put in place so that the money would be available to be paid out to eligible retired individuals. It also ensured that payments could continue during times when investment returns were lower than expected. Private-sector pensions are gradually becoming obsolete, but over 31 million Americans are still covered by them.
Pensions, in general, are considered qualified employer-sponsored plans, which makes them subject to required minimum distribution (RMDs) rules. This means participants must begin taking distributions at the age of 73 or face a hefty penalty. (The age was raised to 73 from 72 as of Jan. 1, 2023.)
Provisions for distributions before 73 can vary. Many participants begin distributions at the age of 65.Â
Social Security
Although many people who are retired receive Social Security benefits, the Social Security system isn’t considered a pension. It may look like a pension because upon retirement (if you have paid into the system during your working years), you are eligible to receive monthly benefits. These benefits can begin at the age of 62.
The amount of the check varies based on the age at which you begin receiving benefits as well as how many years you worked and the amounts you earned while you were contributing to the program. Social Security isn’t designed to fully replace your income or meet all of your financial needs in retirement.
Social Security is funded by a pay-as-you-go system. This means that while you are working, you pay into the system. On your pay stub, the entry for Social Security taxes is listed as FICA. Some of the payments you make while working go to fund current retirees’ benefits.
Key Similarities
At their core, pensions and Social Security are somewhat similar. The main commonality lies in their primary purpose: both are designed to provide financial support during retirement. Whether you have one or both, the overarching goal of both types of plans is to alleviate the financial strain that retirees may face by offering a reliable source of income when someone is done working.
Another similarity is the concept of mandatory contributions. Both pensions and Social Security involve contributions from workers or employees during their working years. In the case of pensions, contributions are often made through payroll deductions. This means the employee doesn’t really have a say in contributing; money is simply deposited for them (along with a contribution by their employer). Social Security, on the other hand, involves payroll taxes. In a similar manner, money is deducted from someone’s paycheck (in the form of a tax) to be used for future benefit.
Finally, both pensions and Social Security typically involve a structured payout mechanism. Upon reaching retirement age or meeting eligibility for either, individuals receive regular disbursements. For pensions, this is dictated by their pension plan. For Social Security, this is dictated by the government. In both cases, the ultimate goal is a steady income stream that the individual can rely on.
Key Differences
There are several other distinctions between pensions and Social Security. Social Security has a disability insurance program that extends benefits to workers who become disabled. Pensions normally don’t provide disability benefits unless the employee is disabled in an on-the-job accident.
Although spouses may receive a partial pension payment, it’s unlikely that a child would also benefit from pension income—as is the case with Social Security.
Finally, pensions may offer a lump-sum payout upon retirement. This option is not available through the Social Security system. Both pensions and Social Security may provide an income stream to retirees. Pensions can begin as early as 55, and are usually taken around age 65. Social Security can begin at age 62.
Which Is Better: Pensions or Social Security?
As is the answer with most elements of personal finance, it depends.
Prioritizing a pension over Social Security can be attractive for several reasons. First, pensions often provide a more predictable and potentially higher income stream. The predictability of a fixed income from a pension can also be advantageous who prefer financial stability and want to plan their retirement budget. Pensions may also offer more flexibility in terms of payouts if the plan allows for the choice between payment structures.
There are also some reasons Social Security is better. Pensions are tied to specific employers that can go bankrupt. Social Security is a government-backed program that may have less of a risk of default. Social Security amounts automatically adjust for the cost of living and/or inflation, while pension plans have to deliberately increase future benefits. Last, Social Security is simply a much more popular program that can almost be universally found across many different types of employers.
Does Anyone Get a Pension Anymore?
Most government employees at the federal, state, and local levels continue to get pensions. Police, firefighters, and teachers usually get them.
Their pensions may be getting less generous, though. They have become part of a larger retirement plan that encourages employees to contribute separately to a variation on the 401(k) plan. The 403(b) and the 457, for example, are designed for public and non-profit employees.
Can You Get Both a Pension and Social Security?
Absolutely. All Americans with a work history (and their spouses) are eligible for Social Security, no matter what their income or assets are.
Keep in mind that a portion of Social Security benefits is taxable if the taxpayer’s total income is above a certain level. That level is very low, kicking in at about $25,000 a year. If you have a pension, you’ll probably lose some of your benefits to taxes.
Are Pensions Paid for Life?
Generally, pension payments are for life. However, there are a number of options for how the benefits are paid. For instance, you can take a lower payout in order to guarantee a surviving spouse a continuing payment.
The various options are regulated by the government.
The Bottom Line
Pensions and Social Security operate for the same goal—to provide retirement funds. But they are not funded and structured in the same ways, which leads to different challenges for each.
The federal Social Security system will likely continue to provide aid to the disabled and elderly for many years—though by how much remains to be seen. But the private pension-plan system is dying out and being replaced by defined contribution plans such as IRAs and 401(k) plans.