Saving for retirement can be daunting, but knowing what options are available is a great first step. You might hear the terms 401(k), pension plan, defined benefit plan, or defined contribution plan and start to feel overwhelmed.
What do they all mean, and how do you select the right one? Thankfully, all these terms are not that complicated at their most basic level. While we will leave your investment strategies up to you and your financial planner, this article should explain everything you need to know about the differences between a pension plan and 401(k).
You will know what those fancy words mean and be ready to start putting money away in your retirement account.
Pension vs 401(k): The Short Version
A pension and a 401(k) have a few main differences. The first is how each plan is funded.
- Pension benefits are almost always funded entirely by your employer. That means your employer automatically places money into your account without taking anything from your paycheck.
- However, a 401(k) is funded mainly by the employee. Money is taken from your paycheck and placed into the account. While some employers will match a portion of your contributions, the bulk of 401(k) funding comes from your own money.
- Another key difference is where the risk lies. With a 401(k), you assume the risk of any investments you make. If you make sound investments, then your money grows, and you have more available at retirement.
- If your investments do not pay off, you might be left with too little money when it comes time to stop working.
- On the flip side, the risk of a pension plan lies with your employer. They guarantee you certain benefits upon retirement, and they must assume the risk of the investments they make with the money in the retirement plan.
Lastly, the number and amount of the payments you receive will vary between the two plans. With a 401(k), you can only take withdrawals until your retirement savings is depleted. Once it is gone, you have no more money to use.
However, with a pension plan, you are generally guaranteed payments for life. You cannot change the payout amount, but you will receive them from retirement age until your death.
KEY TAKEAWAYS
- Pension benefits are almost always funded entirely by your employer, and 401(k) plans are funded mainly by the employee, with some employers making matching contributions.
- Upon retirement, a pension can provide a monthly annuity payment for life, or you can elect a lump sum payment, where the entire balance is paid at once.
- Very few companies still offer pension plans; most only offer a 401(k) plan because this shifts the investment risk from the employer onto the employee.
How Does A 401(k) Work
The 401(k) plan is probably one of the most common retirement accounts in the private sector. It functions very similarly to a 403(b) plan.
These accounts are considered defined contribution plans, and according to the IRS, they are also qualified retirement plans because they are protected by the Employee Retirement Income Security Act (ERISA).
- Employees can make tax-deferred contributions to the plan, and these savings are allowed to grow tax-free in the plan until retirement age.
- An employee may make elective deferrals of up to $23,000 per year into his or her 401(k) with additional catch-up contributions of $7,500 per year after age 50.
- The employer match is a big plus for the 401(k), as many for-profit companies offer matching funds to help their employees grow their retirement savings. This normally ranges between 2% and 4% of your salary.
- If you need to withdraw money from your 401(k) before age 59 1/2, you can expect to pay an early withdrawal penalty. The standard 10% penalty will apply in this case.
- Taxes are due upon withdrawal of any tax-deferred 401(k) plans.
- If you change employers, you can perform a rollover of your 401(k). You can transfer the funds into an IRA or 401(k) account with your new employer.
- Some employers might offer a Roth 401(k) option. This allows you to contribute after-tax dollars and enjoy tax-free distributions in retirement on the contributions and gains.
- Most 401(k) plans have a vesting period. You might lose some of your employer’s matching funds if you leave the company before fully vested in the plan. This period can range from a few months to a couple of years.
- Some 401(k) plans allow for loans without penalty, although you should check your plan documentation for specifics. Upon reaching age 73, you will be forced to take the required minimum distributions (RMDs) from your account.
How A Pension Plan Works
Many people wonder, “What is a pension plan?” You might hear a pension plan referred to as a defined benefit plan.
This is because those benefits are clearly defined in the plan documentation, and you do not assume any of the risks from the investments.
- Your employer typically contributes to this plan, although sometimes, both the employer and employee will contribute.
- Upon retirement, you will receive payments from the pension fund, usually based on your age, the number of years you worked for the company (years of service), and your annual salary history.
If the company’s investments in the plan perform poorly, you might see your benefits reduced or not available at all.
However, most private plans are insured by the Pension Benefit Guaranty Corporation (PBGC). Your employer pays this insurance company a monthly premium to ensure your benefits will be available at retirement even if the investment portfolio underperforms.
Upon retirement, you typically have a couple of options for receiving your benefit payouts.
- You can elect to receive an annuity, where you receive monthly payments for life or
- You can choose a lump sum payment, where you get the entire balance at once.
Your choice of option will depend on your finances and situation. However, pension plans are becoming increasingly rare in the private sector.
Very few employers offer these plans today, and they shift more responsibility to the employee to plan for their retirement.
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What If Your Employer Doesn’t Offer Access To A Pension Plan or a 401(k)?
If your employer does not offer either plan, you still need a retirement savings plan! In this case, you would likely choose an individual retirement account or IRA.
These still provide you with a range of investment options, and your financial advisor can help you choose whether a traditional or Roth IRA would be best for your retirement planning situation.
With a traditional IRA, you would make tax-deferred contributions today and pay income tax when you withdraw. With a Roth account, you pay taxes today and enjoy tax-free withdrawals.
TIP
If offered, a pension plan can be a great retirement benefit. However, unlike a 401(k) or IRA, the annuity payments from a pension usually end upon the employee’s death (though some offer survivor benefits to a spouse). With a 401(k), any remaining funds, upon your death, will go to your beneficiaries or estate.
Key Differences Between A Pension Plan And A 401(k)
Now that you understand each kind of plan, we will discuss some of the key differences between the two.
Although both provide retirement benefits, they are not created equal. The first significant difference between the two is who funds the account.
Funding Accounts
With a pension plan, most of the funds come from your employer. However, a 401(k) is primarily funded by employee contributions, although sometimes you may receive an employer match.
Investment Risk
The same is true for the investment risk associated with each plan. Employers take the investment risk with a pension plan, while employees are responsible for investment risk in their own 401(k).
Available Funds In Retirement
The amount of money available to you upon retirement can vary drastically between a pension and 401(k).
With a 401(k), the amount depends entirely upon how much money you contributed (subject to contribution limits) and how well your investments performed. However, a traditional pension payout is based more on your years of service and salary. Defined benefit pension plan payments typically last for life, while 401(k) payments only last until the balance in your account reaches zero.
| Provisions | 401(k) Plan | Pension Plan |
|---|---|---|
|
How is the Account Funded? |
Primarily funded by employee, although some employers will match contributions |
Typically funded fully by employer |
|
Investment & Risk Management |
Investment choides are made by the employee, and the employee owns the risk of investment performance |
Employer manages investments and owns the risk of the investments |
|
Withdrawals & Payments |
Employees can control the amount of withdrawals at retirement age and can be changed each month
Payouts last until the account balance reaches zero |
Payouts defined in plan documentation
Payouts typically last for life |
|
Pre-retirement Control of Money |
Controlled by employees and money can be converted to IRA or moved to another 401(k) upon change of employment |
Controlled entirely by employer
|
The Bottom Line
It is difficult to say whether one plan is better than the other. Many would argue that a traditional pension plan is better because it is fully funded by your employer.
However, these plans are becoming more difficult to find in the private sector. Pension plans today are more common in the public sector, such as government jobs, but a 401(k) can help you achieve your goals just as well.
Some choose to use both plans because their employer matches into their 401(k), which is like free money.
Whichever plan you choose, remember to begin saving early and often and make intelligent investment decisions. When you reach retirement age, you will be glad you did!
Frequently Asked Questions
Absolutely! If you are lucky enough to be employed with a company that offers both a pension plan and a 401(k), then you should take advantage of both.
This will help you save even more money for retirement. Many retirees wish that they had access to both plans so that they would be in a better financial situation after leaving the workforce.
Most pension plans have a vesting period, meaning the money accumulated in your account after you reach that length of employment cannot be taken away.
Some plans are vested after 12 months, and some after 3 or 5 years. Some plans are fully vested, meaning you would receive 100% of the balance in your account if you leave the company, while others are only granted at a certain percentage.
If the account’s investments perform poorly, your benefits could be reduced, but the PBGC insures most private plans to prevent that.
The PBGC guarantees most private pensions, although employers are not under any obligation to provide pension plans.
In rare circumstances, some pensions have been uninsured, and retirees lose their benefits due to poor company or investment performance. These situations are relatively rare, but they do happen.
So, ensure you have other investments in a nice nest egg to help pay for retirement and are not relying 100% on your pension plan for a guaranteed income.
An IRA is an individual retirement account that works similarly to a 401(k). You can contribute funds to the account up to the yearly contribution limit of $7,000.
The investments in this retirement fund can grow tax-free until retirement age. Once you begin to withdraw, the money will be taxed as income.
These accounts are another method by which many people save for retirement. Consult your financial advisor if you need help deciding between an IRA and a 401(k).
One major drawback is that not many employers offer pension plans today. Another drawback is that you cannot control how much money you save for retirement.
Your plan documentation spelled out the benefits you will receive, which usually depend on your salary and the years of service you have with your employer.
You cannot choose to save more to get a larger payout during retirement because your employer has complete control over the plan and the investment choices.
You can find a Social Security Administration office near you by using our SSA office locator and searching for your closest location.
