You might consider yourself lucky if you have a job that provides a pension for your retirement. Pensions are increasingly rare in the private sector—as of 2025, just 9% of workers participated in one. They’re far more common in state and local governments, where 74% of employees participated in 2025.1
Although a pension likely won’t meet all of your retirement income needs, having a steady stream of guaranteed income to combine with other resources like tax-advantaged retirement accounts and Social Security, if you’re eligible, can help quell fears one may have about running out of savings. Some public employees may not be eligible for Social Security because they didn’t pay into the program through paycheck deductions, though they may still be able to get a spousal benefit.
If a pension is part of your retirement picture, it’s critical to understand the ins and outs of your employer’s plan, from eligibility rules to benefit payout options and everything in between.
Understanding how your pension works
If you’ve been working for the same employer for several years, it may have been a while since you revisited your pension plan documents. Whether you’re 1 year or 5 years away from your desired retirement date, now is the time to review your plan’s rules. You may uncover specifics that cause you to reconsider your retirement timing.
1. Benefit formula
Most pension plans calculate benefits based on years of credited service, meaning the number of years you worked at the company and were eligible for the plan, along with your final average salary. For example, say you worked for 25 years and had a final average salary of $100,000. These numbers are typically multiplied by the plan benefit percentage, such as 1.5% or 2%, which represents the rate of pay you earn for each year of service. You might also see this percentage referred to as an accrual rate, crediting rate, or retirement factor.
A standard formula is:
Years of credited service x benefit percentage x final average salary = Annual pension benefit
Locate your plan’s Summary Plan Description (SPD) to find the formula used for your pension benefit, or reach out to Human Resources (HR) at your company.
2. Final average salary
The final average salary for your pension plan is defined in the SPD. There are a few ways plans calculate this figure. It could be based on the last 3 or 5 full calendar years of compensation or could be based on the last full 36 months of compensation, for example.
Knowing exactly how final average salary is calculated is critical. It’s especially important to know the rules if you plan to switch from full-time employment to part-time employment before you fully retire and/or if you will be retiring before the end of a calendar year. Generally, partial calendar months don’t count.
The formula your plan uses to determine your final average salary could encourage you to work longer than planned, particularly if you’re up for a promotion or expecting a raise soon. Working an additional year, or month, or completing the calendar year could boost your final average salary, and therefore your benefit. (For 2 examples of how this works, see the section below: Choosing your retirement date.)
3. Vesting details
Vesting refers to ownership in a retirement plan. In the case of a pension, employees become vested in the plan when they have worked for a specified number of years and they have reached a certain age. This is when they can retire and begin to receive their monthly benefits. If a worker separates from an employer after reaching that age and vesting date, but does not retire from work, they are still typically eligible to receive the pension benefit at a date of their choosing.
Vesting schedules vary from plan to plan. An employer may require a worker to be employed for at least 10 years and have reached age 55 before they’re vested in the pension plan, for example. Some older companies or governments with pension plans may have vesting tiers that categorize participants based on factors like their hire date or their position in the organization. Longer-tenured employees or executives might have lower minimum retirement ages or years of credited service requirements than newer or lower-level employees.
Retiring prematurely, even a month before the vesting date, can affect whether an employee receives their pension or not, so it’s a critical deadline to be aware of. Vesting dates can be highly specific as well, down to the day of a certain month.
In a retirement plan that’s funded mostly by employee contributions, such as a 401(k), vesting schedules apply only to the employer contributions, which typically come in the form of matches. Vesting for these funds can range from immediate to gradually over 3 to 6 years. Participants in 401(k)s always own their personal contributions and can keep them when they separate or retire from a company.
4. Annuity vs. lump sum
One of the most consequential decisions you will make as a pension plan participant is how to receive your benefit. It’s an irreversible decision, so take time to consider all your options well before your planned retirement date and consider consulting a financial advisor.
Usually you’ll have a choice between an annuity and a lump sum. An annuity is a level monthly payment that you receive until your death. After that, your chosen beneficiary may be able to receive a portion of your payments as part of a survivor benefit. The lump sum option is effectively the present value of your projected monthly benefits and will be determined by your pension plan’s actuary.
“An annuity can provide a lot of retirement security, but it’s subject to inflation risk. Only about 5% of pension plans have an inflation adjustment,” says Steven Feinschreiber, senior vice president and head of methodology at Fidelity Investments Strategic Advisers. Taking the lump sum, on the other hand, means you will need to make investment choices yourself and decide how and when to distribute your funds.
“As a general rule you shouldn’t take a lump sum in cash. It’s generally better to roll it over into an IRA to preserve the tax treatment, then you can invest it,” Feinschreiber adds. Because of the potential for tax-deferred growth, the pension rollover IRA may have a higher value and higher taxes once the money is withdrawn through RMDs. The after-tax money should be higher as well, assuming gains. A downside to consider with taking a lump sum and rolling into an IRA is that it opens you up to required minimum distributions (RMDs). As of 2023, the required beginning date (RBD) for RMDs increased to 73 for people who had yet to turn 72. Beginning in 2033, the RBD jumps to 75 for people born in 1960 or later.
If you take the pension as an annuity then you would just owe ordinary income tax on the payments. There is no opportunity for investment growth except if you take the after-tax amount and invest it instead of spending it. Whereas a lump-sum pension rolled over to an IRA will have potential tax-deferred investment growth and RMDs.
Distributions from traditional IRAs and 401(k)s are typically subject to ordinary income taxes. Note that taking your pension as a lump sum (rolled over into an IRA) may lead to an increased RMD and therefore a larger tax bill in your 70s and beyond. Annuity benefits are also subject to federal income taxes (and state income taxes, depending on where you live), but level payments mean you can avoid any tax surprises.
Tip: The Pension Benefit Guaranty Corporation (PBGC) is responsible for protecting benefits in private sector pension plans. If your employer’s pension plan is terminated while you’re employed or retired, the PBGC will step in to pay your benefits, up to the limits allowed by law. Note that payout options differ when the PBGC takes over a company’s plan, and a lump sum is only available under special circumstances.
5. Is pension income taxable?
Pension benefits are treated as ordinary income, so federal taxes are generally withheld from annuity payments, or owed for each distribution you take from a lump sum once it’s been rolled over into an IRA.
Whether your pension benefits are taxable at the state level is also something to consider. This may impact how much you will need to withdraw to meet spending needs if you’ll also be pulling retirement income from tax-deferred accounts like a 401(k) or traditional IRA and those funds are taxed by your state. Savvy timing of your withdrawals can help keep your tax liability stable in retirement.
Choosing your retirement date
Your pension plan documents outline when you can retire with full benefits. If any of the details are unclear, reach out to your HR department for help. You may also want to ask about the latest age you can start benefits. Some plans are required to begin payouts no later than the month after an employee reaches age 70 or 72, for instance, even if they’re still working.
Retiring as soon as you reach your vesting date may not always be the strongest financial choice. Let’s compare 2 hypothetical scenarios where Annie, who has worked for Company ABC for 20 years, is eligible to retire beginning the month after her 55th birthday in 2026. The pension plan uses a benefit percentage of 2% and the average of the last 3 years of the employee’s salary. Below is an illustration of how working an extra year in which Annie earns 10% more than the previous year could increase her pension benefit. For these illustrations we will assume final average earnings are based on whole calendar years of salary compensation.
Option 1: Employee plans to retire in 2027.
2024 salary: $75,000
2025 salary: $78,000
2026 salary: $85,000
Final average salary = $79,333
20 [Years of credited service] x 0.02 [benefit percentage] x $79,333 [final average salary] = $31,733 annual pension benefit
Option 2: Employee is up for a 10% raise in 2027 and therefore decides to retire in 2028.
2025 salary: $78,000
2026 salary: $85,000
2027 salary: $93,500
Final average salary = $85,500
21 [Years of credited service] x 0.02 [benefit percentage] x $85,500 [final average salary] = $35,910 annual pension benefit
Working an extra year before retiring results in a $4,177 boost in yearly pension benefits for the rest of Annie’s life. Remember, these numbers are an illustration. Your personal earnings record and other retirement funding sources, and importantly, the specifics of your pension plan, are significant factors in how and when you may collect your pension. “Don’t rely on your own calculations, always check with HR,” Feinschreiber says.
It’s also important to consider rules and vesting related to your nonqualified deferred compensation (NQDC) plan, if you have one. These plans allow you to defer a portion of your compensation to a future date, often in retirement. It’s essential to coordinate NQDC timing with your pension benefits, since corporate NQDC plan distribution rules are highly specific and generally require scheduling far in advance. For example, an executive may be eligible to receive an NQDC payout in the current year if they retire before January 31st or some other specific date. But retiring after that date means they start to receive the NQDC payout the following year instead.
It’s critical to understand that no matter which NQDC distribution strategy you choose, it's difficult to change the schedule once you've created it. A subsequent distribution election, if allowed by the plan, cannot permit the payment to be paid earlier than originally elected except in cases of extreme hardship, death, or disability—so you can’t simply change your mind and ask for your deferred compensation a year or 2 earlier than your scheduled distribution date.
Good to know: If you have a 457(b) plan—a deferred contribution plan for certain state and local governments as well as certain tax-exempt organizations such as educational institutions—in some instances you may have more flexibility to take distributions, as you would from a 401(k) or 403(b) plan.
What to do before choosing a retirement date with a pension
Take these steps before committing to a retirement date:
- Review pension plan documents.
- Ask HR for your personal schedule, including how claiming at different ages may affect your payout.
- Understand how the specific date you retire can affect your pension and other benefits.
- Factor dates into your broader income and tax plan, including when you are fully vested in your pension plan, the age at which you can retire, and when you expect to claim Social Security.
Pension decisions in the final year before retirement can feel complex, but a clear understanding of vesting and other rules can make them far more manageable. Take the time to review your choices and consider working with financial and tax professionals who can help you navigate the long-term implications.