How Do Pension Funds Work?

Though pensions come in two types—defined-contribution and defined-benefit—the most common type of traditional pension is the defined-benefit plan. During an employee’s working years, the employer contributes to the plan. (With a defined-contribution plan, the employee does, too.) After the employee retires, they receive monthly benefits for the rest of their life from the plan. Their benefits are based on a percentage of their average salary over their highest-earning years of employment. The formula also takes into account how many years they worked for their employer.

How Pension Funds Work

For some years now traditional pension plans have been gradually disappearing from the private sector. Public sector employees—such as government workers—are the largest group with active and growing pension funds.

You can’t usually take early withdrawals or loans from your pension. Private pension plans offered by corporations or other employers seldom have a cost-of-living escalator to adjust for inflation, so the benefits they pay can decline in purchasing power over the years.

Public employee pension plans tend to be more generous than private ones. Whereas many pensions use 1% in their formulas, the nation’s largest pension plan, the California Public Employees’ Retirement System (CalPERS), pays 2% in many instances. In that case, if an employee had 35 years of service and the average of their five highest-earning years was $50,000, could receive $35,000 annually ($2916.67 per month). In addition, public pension plans usually have a cost-of-living escalator.

How Pension Plans Are Regulated and Insured

There are two basic types of private pension plans: single-employer plans and multi-employer plans, which typically cover unionized workers who may work for several employers.

Both types of private plans are subject to the Employee Retirement Income Security Act (ERISA) of 1974. It aimed to put pensions on a more solid financial footing and also established the Pension Benefit Guaranty Corporation (PBGC).

The PBGC acts as a pension insurance fund: Employers pay the PBGC an annual premium for each participant, and the PBGC guarantees that employees will receive retirement and other benefits if the pension fails and cannot pay.

However, the PBGC won’t necessarily pay the full amount retirees would have received had their plans continued to operate. Instead, it pays up to certain maximums, which can change from year to year.

In 2024, the maximum amount guaranteed for a 65-year-old retiree in a single-employer plan who takes their benefit as a straight life annuity is $7,107.95 per month. Multi-employer plan benefits are calculated differently, guaranteeing, for example, up to $12,870 a year for someone with 30 years of service.

ERISA does not cover public pension funds, which instead follow the rules established by state governments and sometimes state constitutions. The federal government also operates pensions for its employees which are regulated as well. Nor does the PBGC insure public plans. In most states, taxpayers are responsible for picking up the bill if a public employee plan is unable to meet its obligations.

How Pension Funds Invest Their Money

ERISA does not dictate a pension plan’s specific investments. However, ERISA does require plan sponsors to operate as fiduciaries. That means they must put their clients’ (the future retirees) interests ahead of their own.

By law, the investments they make are supposed to be both prudent and diversified in a manner that is intended to prevent significant losses.

The traditional investing strategy for a pension fund is to split its assets among bonds, stocks, and real estate.

An emerging trend is to put some money into alternative investments, in search of higher returns and greater diversity. Those investments include private equity, hedge funds, commodities, derivatives, and high-yield bonds.

The State of Pension Funds Today

While some pension funds are in solid shape today, many others are not. For private pension plans, those numbers are reflected in the financial obligations taken on by their insurer, the PBGC.

At the end of its 2023 fiscal year, the PBGC had a net surplus of $46.1 billion. (It was $37.6 billion at the end of 2022.) That consisted of a $44.6 billion surplus in its single-employer program (it was $36.6 billion at the end of 2022), and a 1.5 billion surplus in its multi-employer program (it was $1.1 billion at the end of 2022).

The American Rescue Plan Act of 2021 includes provisions to help the PBGC strengthen multi-employer plans. Plans that face serious financial trouble are eligible to apply for special assistance in the form of a single, lump-sum payment calculated to cover the plan’s obligations through 2051. The money to fund this program is from the U.S. Treasury’s general tax revenues.

State and local pension plans also present a mixed picture. While a handful of state plans have 100% of the funding they need to pay their estimated future benefits, most have considerably less. 2023 saw slight improvements, though large problems still exist. Overall, the percent of funded liabilities improved, and reached 78.1% during 2023. Unfunded liabilities declined to $1.44 trillion. Problems remain, despite a change towards the positive direction.

The Bottom Line

Many people who have access to a pension consider themselves lucky, at least in the corporate world. (If you’re a public worker, though, you’re far more likely to have one.) A pension differs from a 401(k) in several ways, but what it comes down to is the guarantee: with a pension, when you retire, you’re covered for life. With a 401(k), that’s not necessarily the case.