The term “pension” may evoke images of a bygone era, a time when an employee could work for a single company for thirty years and retire with a guaranteed income for life.

While less common in the private sector today, understanding what a pension is, how it functions, and why it remains a valuable retirement tool for some could inspire you to pursue such a plan. And even if your employer does not offer you a pension, you may be able to invest in a similar program as you plot your financial future.

What exactly is a pension?

Formally known as a defined benefit (DB) plan, this is a retirement vehicle entirely funded and managed by an employer. Unlike other retirement savings accounts, where the employee contributes and assumes the investment risk, the employer promises to pay the employee a specific, predetermined income stream upon retirement. The income is typically paid out monthly for the rest of the retiree’s life.

The amount of the payment is usually calculated using a formula that takes into account three main factors: the employee’s salary (often the average of the highest-earning years), the number of years worked for the company, and a pre-set multiplier defined by the plan. For instance, a formula might grant 1.5 percent of the final average salary multiplied by the number of years of service.

The employer bears the investment risk and is responsible for ensuring the pension fund has enough assets to cover all promised future payments to its retirees. The employee generally only needs to meet the plan’s vesting period: the length of time required to work for the company to become eligible to receive the full benefit.

The shift to defined contribution plans

Over the last few decades, most private companies have moved away from defined benefit pensions due to the high and unpredictable costs as well as the substantial investment risk they place on the employer. They have largely been replaced by defined contribution (DC) plans, such as the 401(k).

In a 401(k) plan, the employee contributes money (and sometimes receives an employer match), and the employee directs how the funds are invested. The employer makes no guarantee about the final payout; the retirement income depends entirely on the total contributions and the market performance of those investments. This shifts the investment risk and responsibility squarely onto the employee.

Common alternatives for retirement planning

For the vast majority of workers who are not offered a traditional pension—and this includes a huge portion of private-sector employees—there are excellent, accessible alternatives that empower them to build their own retirement security:

• 401(k) plans (employer-sponsored): If offered by an employer, this is generally the most straightforward and beneficial option, particularly if they offer a matching contribution. These plans allow pre-tax contributions, reducing current taxable income, and the funds grow tax deferred.
• Individual Retirement Accounts (IRAs): These are self-directed accounts that anyone with earned income can open. Traditional IRAs allow for tax-deductible contributions (depending on income), and funds may increase tax deferred. Roth IRAs use after-tax contributions, but all qualified withdrawals in retirement are tax-free.
• Brokerage accounts: For funds saved beyond the limits of 401(k)s and IRAs, a standard taxable brokerage account allows you to invest in stocks, bonds, and mutual funds. While growth is taxed annually, these accounts offer competitive liquidity and flexibility.

While the nearly guaranteed income from a pension is hard to replace, using these alternatives effectively, especially by maximizing employer matches and contributing regularly, can help you build a strong, diverse portfolio. This approach allows you to plan your retirement with more confidence. To explore these options and more for your golden years, consider consulting a financial professional.