Saving for retirement can be a daunting task, but knowing what options are available is a great first step. You might hear the terms 401k, 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 one that is right for you? 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 all those fancy words mean, and you will be ready to start putting money away in your retirement account.
Pension vs. 401(k): The Short Version
There are a few main differences between a pension and a 401(k). The first is the way each plan is funded. Pension benefits are almost always funded completely by your employer. That means that your employer is automatically placing money into your account without taking anything from your paycheck. A 401(k), however, is funded mostly 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 funding for the 401k comes from your own money.
Another key difference is where the risk lies. With a 401(k), you assume the risk of any investments that you make. If you make great investments, then your money grows and you have more available at retirement. If your investments do not pay off, then 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 basically guarantee you certain benefits upon retirement, and they must assume the risk of the investments that 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 amount of the payments, but you will receive them from retirement age until your death.
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 risk from the investments. Your employer typically makes the contributions 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 investments that the company makes in the plan perform poorly, then 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 a monthly premium to this insurance company to make sure that 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. Which option you choose will depend on your personal finances and your specific situation. You should know that pension plans are becoming more and more rare in the private sector. Very few employers offer these plans today, and they shift more responsibility to the employee to plan for their own retirement.
How A 401(k) Plan Works
A 401(k) plan is designed for an employee to be responsible for most of their own retirement savings. This is even the case when a self-employed individual opens a solo 401(k) account. An employee typically makes pre-tax contributions to the plan, and the employer will often match those contributions. Investments vary depending on the specific plan, but they are often made in mutual funds, stocks, or other publicly traded securities. The money in the plan grows tax-free with no cap, although there is also no guarantee that the investment will grow at all. In fact, you could end up losing money if your investments do not perform well.
When it comes time to start getting your retirement income, you will make withdrawals from your account. If you withdraw your money before age 59 1/2, then you will likely pay heavy tax penalties unless you know how to make an early withdrawal without a penalty. Unlike Social Security or a pension, the amount that you withdraw each month can vary. However, there is no guarantee that you will have enough money to last until your death. When the 401(k) runs out, then you cannot make any additional withdrawals.
Key Differences Between A Pension Plan And A 401(k)
Now that you understand what each kind of plan is, we will discuss some of the key differences between the two. Although both provide you with retirement benefits, they are not created equally. The first major difference between the two is who funds the account. With a pension plan, most of the funds come from your employer. However, a 401(k) is mostly funded by employee contributions though sometimes you may receive an employer match. The same is true for the investment risk associated with each plan. Employers take the investment risk with a pension plan, while an employee is responsible for investment risk in their own 401(k).
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.
| Pension Plan vs 401(k) Comparison | ||
|---|---|---|
| Pension Plan | 401(k) Plan | |
| How is account funded | Typically funded totally by employer | Mostly funded by employee, although some employers will match contributions |
| Investment & risk management | Employer manages investments and owns the risk of the investments | Investment choices are made by the employee, and the employee owns the risk of investment performance. |
| Withdrawals & payouts | Defined in plan documentation. Payouts typically last for life. | Employees can control the amount of withdrawals at retirement age and can change them each month. Payouts last until the account balance reaches zero. |
| Pre-retirement control of money | Controlled entirely by employer | Controlled by employees and money can be converted to IRA or moved to another 401(k) upon change of employment. |
What If Your Employer Doesn’t Offer Access To A Pension Plan Or A 401(k)?
If your employer does not offer either type of 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 personal retirement planning situation. With a traditional IRA, you would make tax-deferred contributions today and pay income tax when you make withdrawals. With a Roth account, you pay taxes today and enjoy the withdrawals tax-free.
The Bottom Line: Is A 401(k) Or A Pension Plan Better?
It is difficult to say whether one plan is better than the other. Many people would argue that a traditional pension plan is better because it is fully funded by your employer, although these plans are becoming more difficult to find in the private sector. Pension plans today are more common in the public sector like government jobs, but a 401(k) can help you achieve your goals just as well. In fact, some people choose to use both types of plans because their employer match into their 401(k) is like free money. Whichever plan you choose, just remember to begin saving early and often and make smart investment decisions. When you reach retirement age, you will be glad you did!
Frequently Asked Questions
Can you have both a pension and a 401(k)?
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.
Can my pension be taken away?
Most pension plans have a vesting period which means that 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 as long as 3 or 5 years. Some plans are fully vested, meaning that you would receive 100% of the balance in your account if you leave the company, while others are only vested at a certain percentage. If the investments in the account perform poorly, it is possible that your benefits could be reduced, but most private plans are insured by the PBGC to prevent that from happening.
Are pensions guaranteed?
Most private pensions are guaranteed by the PBGC, although an employer is under no obligation to provide a pension plan at all. In rare circumstances, some pensions have been uninsured and retirees lost out on their benefits due to poor company or investment performance. These situations are fairly rare, but they do happen. So, make sure that you have your own investments in a nice nest egg to help pay for retirement and are not relying 100% on your pension plan for a guaranteed income.
What is an IRA and how does it work?
An IRA is an individual retirement account, and it works similarly to a 401(k). You can contribute funds to the account up to the yearly contribution limit of $6,000. The investments in this retirement fund can grow tax-free until retirement age. Once you begin to make withdrawals, the money will then be taxed as income. These accounts are another method by which many people choose to save for retirement. If you need help deciding between an IRA and a 401(k), you should consult your financial advisor.
What are some drawbacks of a pension?
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. The benefits that you will receive are spelled out in your plan documentation, and they usually depend on your salary and the years of service you have with your employer. You cannot choose to save more in order to get a larger payout during retirement because your employer has full control over the plan and the investment choices.
