What Does a Deferred Pension Mean?
What is a deferred pension? Understand its definition, how its value grows, and the different ways to access this earned retirement benefit.
A pension plan represents a retirement savings benefit that employers may offer to their employees, typically involving contributions to a fund designed to provide payments after retirement. These traditional plans, often called defined benefit plans, promise a predetermined monthly income during retirement, usually based on factors like years of service and salary. While many modern retirement plans, like 401(k)s, involve employee contributions and investment choices, pensions traditionally place the funding and investment burden primarily on the employer. A deferred pension specifically refers to a vested benefit an individual has earned from an employer’s defined benefit plan, which has not yet begun to be paid out.
What Constitutes a Deferred Pension
This status commonly arises when an individual leaves employment before reaching the pension scheme’s normal retirement age. In such cases, the accrued pension benefit is preserved and will be paid at a later date, typically at the plan’s specified retirement age. The closure or winding-up of a pension scheme can also lead to benefits being deferred, securing earned entitlements for future payment.
Vesting is fundamental to a pension becoming deferred, meaning an employee has earned a non-forfeitable right to a future pension. Federal law, the Employee Retirement Income Security Act of 1974 (ERISA), sets minimum standards for vesting in private industry plans. For defined benefit plans, an employee typically becomes 100% vested after five years of service under a “cliff vesting” schedule, or gradually over seven years under a “graded vesting” schedule, where at least 20% vesting occurs after three years and increases thereafter. This ensures the employee has a right to the accrued benefit, even if they leave the employer.
How Deferred Pensions Are Calculated and Adjusted
The initial amount of a deferred pension is typically determined by a formula that considers the employee’s length of service and salary at the time they stopped accruing benefits. For example, some plans might use a “high-3” average salary, which is the average of the employee’s highest three consecutive years of basic pay. This calculation establishes the baseline for the future benefit.
Revaluation or indexing adjusts the benefit amount over time from the date of deferral until payments begin. This adjustment preserves the purchasing power of the benefit, often linking it to inflation, a fixed percentage, or statutory minimums. While the initial calculation uses the salary and service at the point of deferral, revaluation ensures the benefit grows during the deferral period.
Actuarial adjustments apply if the pension is taken earlier or later than the plan’s normal retirement age, often 65. Taking the pension before this age typically results in an “actuarial reduction” to the annual amount, as payments will be made over a longer period. Conversely, deferring payment beyond the normal retirement age can lead to an “actuarial increase,” as payments will be made over a shorter duration.
Options for Receiving Your Deferred Pension
Once a deferred pension becomes available for payment, individuals have several options for receiving their benefits. One option is to begin receiving the pension at the scheme’s designated normal retirement age, which is often 65. At this age, the full accrued and revalued benefit typically becomes payable.
Many plans offer “early retirement,” allowing individuals to start receiving benefits before the normal retirement age, often as early as age 55 in private plans. However, choosing early retirement usually results in an actuarial reduction to the monthly benefit, reflecting the longer period over which payments will be made.
Conversely, an individual may choose “late retirement,” deferring the start of pension payments beyond the normal retirement age. This can lead to an actuarial increase in the annual benefit, as the total payout period is shortened. Pension credits may continue to accrue and increase each year until a certain age, often age 70.
Some pension plans also provide a lump sum option, either as an alternative to a regular income stream or as a partial commutation of the pension. This allows the individual to receive the present value of their future pension benefits in a single payment. If a lump sum is chosen, it is typically subject to income taxes, though a direct rollover to an Individual Retirement Account (IRA) or another qualified retirement plan can help defer these taxes and consolidate the benefit.