How Do Pension Funds Work? (2024)

The most common type of traditional pension is a defined-benefit plan. After employees retire, they receive monthly benefits from the plan, based on a percentage of their average salary over their last few years of employment. The formula also takes into account how many years they worked for that company. Employers, and sometimes employees, contribute to fund those benefits.

As an example, a pension plan might pay 1% for each year of the person's service times their average salary for the final five years of employment. So an employee with 35 years of service at that company and an average final-years salary of $50,000 would receive $17,500 a year.

How Pension Funds Work

For some years now, traditional pension plans, also known as pension funds, 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 spending power over the years.

Public employee pension plans tend to be more generous than private ones. For example, the nation’s largest pension plan, the California Public Employees’ Retirement System (CalPERS), pays 2% per year in many instances. In that case, an employee with 35 years of service and an average salary of $50,000 could receive $35,000 annually. In addition, public pension plans usually have a cost-of-living escalator.

The United Kingdom categorizes pensions as Tier 1 or Tier 2 pension plans. Tier 1 plans offer guaranteed payout based on the years of service. The payout for Tier 2 plans depends on the performance of the returns of invested contributions.

How Pension Plans Are Regulated and Insured

There are two basic types of private pension plans: single-employer plans and multi-employer plans. The latter 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 employer goes out of business or decides to terminate its pension plan.

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

In 2021, 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 $6,034.09 per month. Multi-employer plan benefits are calculated differently, guaranteeing, for example, up to $12,780 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. 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 commercial real estate. Many pension funds have given up active stock portfolio management and now only invest in index funds.

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 2020 fiscal year, the PBGC had a net deficit of $48.2 billion. That consisted of a $15.5 billion surplus in its single-employer program but a $63.7 billion deficit in its multi-employer program.

The Congressional Research Service reported that "PBGC projects the financial position of the single-employer program is likely to continue to improve, but the financial position of the multi-employer program is expected to worsen considerably over the next 10 years."

However, that assessment was written before the passage of the American Rescue Plan Act of 2021 in March 2021. It includes provisions intended 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 the year 2051. Rather than insurance premiums, the money to fund this program is to come 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. The Equable Institute recently predicted that "the average funded ratio will decrease from 72.9% in 2019 to 69.4% in 2020."