403(b) Plans and Pensions

June 13, 2023

By Barbara O'Neill, CFP®, AFC®

Are you familiar with the “3-legged stool” metaphor used to describe retirement planning? It has been used for decades to indicate that Social Security was never meant to be a sole source of retirement income. Instead, there are two other legs: pensions and personal savings. Over the past 40 years, however, pensions have largely disappeared for most workers. Public employees, including teachers, are a notable exception. 

Only 1 in 5 teachers, however, get a full pension and more than half of those who teach never get any pension at all. In addition, nearly 40% of teachers are not covered by Social Security. In other words, that 3-legged stool is wobbly, making personal savings in 403(b) plans and IRAs essential for adequate income in later life. Some 403(b) participants live with a toppled-over “2-legged stool” or they replace a missing “leg” with income from post-retirement work or passive income (e.g., rent). A fortunate minority have a “4-legged table” (pension, Social Security, savings, and earned income). Full disclosure: I am part of this later group.

This post takes a “deep dive” into defined benefit (DB) pension plans as a foundational source of income for many 403(b) plan participants. It describes vesting requirements, benefit calculation methods, taxation, and what happens when pension recipients (or their spouse) pass away. It also includes a study about teachers’ retirement planning knowledge, as well as three “need to know” facts and six take-away action steps.

Defined Benefit Pensions

Defined benefit pensions provide a fixed amount of lifetime monthly income following retirement. As the name suggests, the benefit amount is formula-based (defined). Public pensions typically require employee contributions. Example: I contributed 7% of my pay when I worked at Rutgers University. 

Because DB pensions promise a specific benefit amount, employers bear the investment risk of accumulating sufficient assets. Unfortunately, many public pensions are underfunded (i.e., they lack enough cash to cover benefits promised to retirees) as a result of government budget cuts and/or poor investment decisions. 

As a result of funding shortfalls, some pension administrators have created lower benefit tiers for new hires, increased employee contributions, and/or lowered or eliminated retiree cost-of-living adjustments (COLAs).

Pension Vesting

Rights to a DB pension are dictated by an employer’s vesting schedule. Vesting refers to the date when employees are entitled to money that their employer (e.g., school district) made on their behalf and can qualify for a future pension benefit at a plan-specific “normal retirement age.”

Typical vesting periods are five to ten years of service. If pension rights are not vested, workers can typically get back only their own contributions, sometimes with interest (e.g., if they leave the teaching profession or move to a different state). 

Benefit Calculation Formulas

There are three parts to a DB pension formula: 

1. Benefit Accrual Rate: Expressed as a percentage (e.g., 2%), this is how much of an employee’s average salary is received as an annual pension benefit. Some pensions have benefit accrual tiers based on years of service (e.g., 1.5% for first five years, 1.75% for next five years, and 2% for service beyond ten years).
2. Average Salary: Some type of average salary calculation such as the highest three or highest five years of earnings or the highest X consecutive years of earnings.
3. Years of Service: The length of time that an employee worked for an employer.

The formula is applied as follows:

Average Salary x Benefit Accrual Rate x Years of Service = Annual DB Pension Benefit

Some examples:

• $60,000 x .015 (1.5%) x 25 = $22,500 annual/$1,875 monthly
• $60,000 x .015 (1.5%) x 30 = $27,000 annual/$2,250 monthly
• $60,000 x .02 (2%) x 25 = $30,000 annual/$2,500 monthly
• $60,000 x .02 (2%) x 30 = $36,000 annual/$3,000 monthly
• $65,000 x .02 (2%) x 25 = $32,500 annual/$2,708 monthly
• $65,000 x .02 (2%) x 30 = $39,000 annual/$3,250 monthly

As shown above, the largest DB pension benefits occur with higher benefit accrual rates (2% versus 1.5%) for employees with many years of service who reach the top of their employer’s pay scale. Other plan-specific features, such as early retirement benefit reductions and cost-of-living adjustments, may apply. The biggest increases in pension value typically occur during the last five years of a 30-year career.

Pensions and Income Taxes

Pension payments are taxed at a retiree’s ordinary federal income tax rate, minus a pro-rated amount that reflects employee contributions to the pension. In other words, retirees don’t pay tax on a portion of their pension that consists of money that was previously taxed. 

The plan custodian will indicate the “gross distribution” (full pension payment) and taxable amount on Form 1099-R, along with the amount of federal and/or state tax withheld. State income tax rules for pension income vary. Some states do not  have an income tax and some states do not tax pension income.

Pensions Upon Death 

Pensions have plan-specific rules for survivor benefits for single and married retirees. For example, with my pension, a spouse is entitled to 55% of the earned annuity if the pension recipient dies first. If the annuitant’s spouse dies first, the survivor benefit reduction for the joint annuity stops. However, reductions from pension payments made before the spouse passed are not reimbursed. If no survivor annuity is payable (e.g., single retirees), remaining retirement contributions, plus interest, are payable in a specific order of precedence.

Pensions: A Piece of the Retirement Income Pie

In an earlier post, several retirement planning calculators were listed with a suggestion to try at least three because they have different data inputs and assumptions.  During the process of entering data, it is easy to  approximate what portion of retirement living expenses a pension might provide. Average annual teacher pensions vary significantly from state to state and range from the $20,000s to the $40,000s, depending on state living costs and employer pay scales.

While certainly better than what most workers have (i.e., no pension) and a key retirement income source, teacher pensions, alone, are often not enough to cover all living expenses in later life. Savings in a 403(b) plan, IRA, and/or taxable account(s) plus Social Security (via teaching jobs or “side hustles” where teachers are not covered) can close the gap; i.e., “3-legged stool” of pension + savings + Social Security.

Example: 

$100,000/year income goal for married two-earner couple (one long-time 403(b) participant with a pension)

$35,000 from (1) pension (35%)

$33,000 from (2) Social Security benefits (33%)

$32,000 from part-time work, investment income (e.g., interest, dividends, capital gains), and/or savings withdrawals, including 403(b) account (32%)

Research Results

Adequate retirement savings requires both planning and knowledge about retirement savings options. A study by Fuchsman et al. explored teachers’ knowledge and retirement preparation using a nationally representative sample of teachers from RAND’s American Teacher Panel. They found that many teachers lack basic retirement knowledge necessary to plan effectively. 

Specifically, teachers struggled to identify their plan type, how much they contributed to their plans, retirement eligibility ages, and who contributes to Social Security. Experienced teachers demonstrated more knowledge. A key implication is that teachers need more education about their retirement benefits from teacher preparation programs, employers, and professional and non-profit organizations (e.g., 403bwise).

Three (More) Things

• Some individuals with a pension plan may have a greater willingness to take more investment risk in their 403(b) and/or other investments because pensions provide the security of guaranteed income. As always, it is important to assess personal risk tolerance when making investment decisions.
• A summary plan description (SPD) is the document that provides information about a specific pension (e.g., plan features such as vesting, eligibility age, and spousal benefits). It should be requested if not provided as a requirement of state law.
• A minority of high-earning, long-tenured pension recipients (e.g., school administrators, full professors, and two-pension couples) may have benefits that are larger than later life living expenses. Professional advice can be useful to explore options for “excess savings” in a 403(b) or elsewhere.

Six Smart Strategies

No. 1: Know Your Plan — The SPD and individual benefit statements should be requested if not provided automatically. Review them carefully, paying particular attention to the vesting period, eligibility age, and benefit calculation formula for the pension tier in effect at the time of hiring.

No. 2: Consider an Encore Career — Many 403(b) plan participants use their pension eligibility date, usually between age 55 and 60, as a de facto retirement date. Early retirement leaves a decade or more before age 67 or 70 to continue working to earn income, save more money, and receive Social Security delayed retirement credits.

No. 3: Save Beyond Your Pension — Most teacher pensions are modest and need to be supplemented by a 403(b) plan, IRAs, and other savings. This savings should begin at the start of a teaching career so that it earns decades of compound interest.

No. 4: Withhold Taxes on Pension Income — Pension plan administrators will withhold income taxes if they are directed to do so. Otherwise, quarterly estimated taxes are required. Many people use a 20% federal tax withholding rate to approximate what they owe. Example: $3,000 (gross monthly payment) - $600 (20% tax withholding) = $2,400 (net payment).

No. 5: Beware of “Pension Envy” — “Pension envy” is real and can occur in discussions about finances with pension-less friends and family who get vocal by publicly wishing that they had a stream of retirement income they could count on. 

No. 6: Keep Current with Pension Changes — Pension promises are subject to change and cash-strapped state governments have been making changes such as reduced or frozen COLAs, benefit cuts, and raised age and work tenure requirements for new hires. 

In Summary

For most public sector workers, pensions are a base to build on- not a sole source of retirement income to pay living expenses. The more additional sources of income retirees have, such as a 403(b) account, the more secure their finances will likely be.

This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.

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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.

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