What is a Pension Fund?
A pension fund is an investment fund created by an employer to provide employees with an income during retirement.
It is a pool of money invested in financial assets that are expected to grow enough to pay retirement benefits in the future.
Pension funds have decreased in popularity because they put financial strain on organizations that bear the responsibility of making payments to retired employees for many years in the future.
Instead, 401(k) plans and other types of retirement accounts have emerged, with their own advantages and disadvantages.
How a Pension Fund Works
In a pension fund system, employees are promised retirement benefits in exchange for their years of work.
The retirement benefits are valued based on a formula that generally takes into account the employee’s job title, annual salary, and years of service. If an employee spends their entire career at a company and achieves a prestigious job title and a high salary, their retirement benefits could be worth a lot of money.
Retirement benefits make up a large portion of how employees are compensated. Organizations have a legal and financial responsibility to follow through on commitments to pay workers when they retire.
Therefore, retirement benefits represent a financial liability to companies, just as they have debt liabilities to the banks they borrow money from.
Organizations need to plan carefully in order to have enough money to pay out retirement benefits to employees; that is why they create pension funds. Pension funds allow organizations to match assets with the future liabilities of paying retirement benefits.
As workers earn retirement benefits through their years of service, organizations will set aside money each year in a pension fund.
The money in a pension fund is invested in a portfolio of financial assets such as stocks, bonds, real estate, private equity, and venture capital funds. If a pension fund generates a good return on its investments, it can afford to pay out retirement benefits while contributing less money up-front.
However, if an organization doesn’t contribute enough money to a pension fund or generates a low return, it can face significant financial strain when the time comes to pay out retirement benefits.
Many companies have gone bankrupt due to an inability to meet their pension liabilities.
Pension Plans vs. 401(k) Plans
Pension plans are often compared to 401(k) plans because both serve as vehicles to provide people with financial security during retirement.
401(k) plans have recently become more popular because they transfer the financial risk of saving and investing from the company to the employee. Many employees prefer 401(k) plans because they provide more investment flexibility and allow them to switch jobs without the risk of losing all their retirement benefits.
In a 401(k) plan, employees are given the option to contribute to a 401(k) account, which can be invested in financial assets to be used in retirement. The 401(k) account holder chooses how their account will be invested based on a menu of choices ranging from conservative bond funds to aggressive growth stock funds.
When a 401(k) owner retires, the value of their retirement assets is based on how much they contributed to their account over the years (how much they saved for retirement) and how well their investments performed.
Because 401(k) accounts are reliant upon employee contributions, they are referred to as defined contribution plans. On the other hand, pension funds guarantee retirement benefits and are therefore referred to as defined benefit plans.
The other important distinction is that pension benefits are determined by the number of years an employee has worked for an organization and often take many years to vest. If an employee has not spent enough time working at a job for their benefits to vest, they are not yet entitled to the benefits. If they leave the company before they have vested, they will lose their retirement benefits.
This is in contrast to a 401(k) account in which, if an employee has made contributions to the account out of their paycheck, that money belongs to them and travels with them when they switch jobs.
A 401(k) account may also feature employer contributions which may take time to vest, but the policy on employer 401(k) contributions varies on a case-by-case basis.
The table below summarizes the differences between 401(k) plans and pension plans.