A pension is a financial arrangement by which workers receive an ongoing income after their working days are over, or essentially retirement pay. They can be sponsored by private employers, by governments and agencies, or even created by the workers themselves through long-term savings and annuities. Pensions come in two broad categories -- defined benefit pensions and defined contribution pensions.
Defined Benefit Pensions
Defined benefit pensions are what we frequently think of as traditional pension plans. With a defined benefit plan, the employer guarantees the worker a specific amount per month or per year in retirement, regardless of market conditions. The plan sponsor, then, is assuming all the risk of market underperformance.
Defined Contribution Pensions
In a defined contribution plan, there are no guarantees or promises of a specific level of retirement income. Instead, workers and employers contribute to a workplace pension plan, such as a 401k, 403b, or simple IRA. Contributions are generally not taxed until money is withdrawn in retirement. The worker retains the risk of poor investments or market underperformance, but gains the benefit of good performance and has more freedom to select his own investments. However, workers can insulate themselves somewhat from market volatility by choosing annuities that pay a guaranteed payout in retirement, sidestepping market risks. They also forego future market gains.
Pension benefits are the income paid out by pension plans. While pensions are not typically taxed during the accrual phase, they are generally taxable as ordinary income in retirement, when the worker begins to receive the income. For tax-deferred pension plans such as 401ks, the worker must begin taking withdrawals, and paying taxes on those withdrawals, by April 1 of the year following the year in which they turn 70 and a half. These mandatory withdrawals are called "required minimum distributions."
Annuitized pension benefits are instrumental in protecting workers against longevity risk, which is the risk that workers will outlive their retirement nest eggs. Workers who benefit from traditional defined benefit pensions, or who have annuitized their defined contribution plan benefits on retirement can receive a guaranteed income for as long as they live, regardless of market performance (contingent on the claims-paying ability of the insurance company backing the annuity.)
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