Accrued Pension Benefits: How Do They Work?

An accrued pension benefit is the amount of retirement income an employee has earned within a defined benefit (DB) pension plan at a specific point. These plans, also known as traditional pensions, promise a pre-determined payment upon retirement. The employer funds and manages the plan, bearing the investment risk.

In contrast, a defined contribution (DC) plan, such as a 401(k), does not have a guaranteed outcome. With a DC plan, the employee and often the employer contribute to an individual account, and the final benefit depends on investment performance, with the employee bearing the risk.

Understanding Vesting in Your Pension

Vesting is the point at which your right to the future retirement income from your employer becomes non-forfeitable, even if you leave the company before retirement age. Before you are vested, you are only entitled to any contributions you may have made, not the benefit funded by your employer. The rules governing vesting are established by the Employee Retirement Income Security Act of 1974 (ERISA).

Pension plans use one of two main vesting schedules. The first is “cliff vesting,” where an employee becomes 100% vested after a specific period, with no partial ownership before that date. A cliff vesting schedule for a defined benefit plan cannot require more than five years of service. For example, with a five-year rule, an employee with four years of service has no right to the employer-funded benefit, but an employee with five years has a right to all of it.

The second schedule is “graded vesting,” where ownership occurs in stages. Federal law requires employees be at least 20% vested after three years of service, increasing by 20% each year until they are 100% vested after seven years. For instance, an employee might be 40% vested after four years and 60% after five. To understand your plan’s specific rules, consult the Summary Plan Description (SPD) your employer must provide.

The Calculation of Your Accrued Benefit

The amount of annual income you will receive in retirement is determined by a formula based on your years of service and compensation history.

One common method is the final average pay formula. This calculation uses your years of service, a percentage multiplier (or accrual rate), and an average of your highest earnings over a specified period, like the final three or five years. For example, with a 1.5% multiplier, an employee with 30 years of service and a final average salary of $80,000 would have an annual pension of $36,000 (30 x 1.5% x $80,000).

Another approach is the career average pay formula, which uses your average earnings over your entire career with the employer. This method can result in a lower benefit than a final average pay formula if your salary increased significantly in later years. A third method is the flat benefit formula, which provides a fixed dollar amount for each year of service, such as $80 per month.

Your employer must provide you with an annual pension statement detailing your personal accrued benefit as of a certain date. This statement shows the monthly pension you have earned and would be entitled to at retirement age if you stopped working at that moment.

Options for Receiving Pension Payments

Once vested and at retirement age, you must decide how to receive your accrued benefit. Plans define a “normal retirement age,” often 65, when you can receive your full benefit. Many plans also offer an “early retirement” option, but this will result in a permanently reduced monthly payment to account for the longer payout period.

The most common payment form is a single-life annuity, providing a fixed monthly payment for the retiree’s life. This option offers the highest possible monthly payment because it ceases upon the retiree’s death, with no further benefits paid to a spouse or other beneficiaries.

For married participants, plans must offer a joint and survivor annuity. This option provides a monthly payment for the retiree’s life and continues payments to the surviving spouse after the retiree’s death. Common choices include a 50%, 75%, or 100% survivor benefit, meaning the spouse receives that percentage of the original payment, which results in a lower initial amount.

Some pension plans may offer a lump-sum distribution, allowing you to take the entire present value of your future pension payments at once. This provides flexibility but transfers all investment and longevity risk to you. Pension benefits are taxed as ordinary income in the year they are received.

Impact of Changing or Leaving Your Job

If you leave your job after becoming vested but before retirement age, your accrued benefit remains yours. The most common path is to leave the money in the former employer’s pension plan as a deferred pension. You will not receive payments until you reach the plan’s retirement age, at which point you file a claim with the plan administrator.

If the plan allows, you may have the option to take a lump-sum payout of your vested benefit when you leave your job. Taking this as cash would trigger immediate income taxes and a potential 10% early withdrawal penalty if you are under age 59½. This penalty is often waived for employees who leave their job in or after the year they turn 55.

To avoid immediate taxes on a lump-sum payout, you can execute a direct rollover. This transfers the funds from the pension plan to an Individual Retirement Account (IRA), preserving the tax-deferred status of the money until you withdraw it in retirement.