Pension vs. 401(k): Distinguishing Between These Common Retirement Plans
For today’s working folks, retirement planning looks much different from how it did for their parents and grandparents.
Social Security benefits are likely to cover only a fraction of retirement needs, and unlike in decades prior, making up that shortfall is left to the individual.
This change is driven by a shift in the type of retirement plans now offered in most workplaces. Your grandparents may have retired with pension benefits. You’re more likely to rely on a nest egg you build up in a 401(k).
The two plans actually have little in common. In this article, we’ll explain the differences between a pension vs. 401(k) and how those distinctions affect your planning now.
How the Plans Differ
A generation ago, millions of Americans worked in jobs that provided a pension. Many people stayed with the same company for decades — their entire career, even — accruing benefits in a pension plan that would pay them a fixed amount for life after they retired. Today, many government entities still offer traditional pensions, but they are rare in the private sector.
If you work for a private company, you’re more likely to be offered participation in a 401(k) plan, which you and/or your employer contribute money to pre-tax.
The main difference between the plans is in who bears the investment risk.
In a pension, all the risk is on the employer. Considered a defined benefit plan, a pension pays a fixed amount, for life, to retirees. If the plan’s investments don’t perform well enough to cover those obligations, the company must make up the difference. And if the company goes under, your benefits are insured — and therefore guaranteed — by the Pension Benefit Guaranty Corporation.
In a 401(k), which is a defined contribution plan, the amount you get in retirement is not guaranteed. It’s determined by how much money you invest and how well those investments perform. That means all the risk is on you.
In 1998, 59% of Fortune 500 companies offered employees a pension plan; in 2019, just 14% of these companies still offered such a plan.
Why such a dramatic shift? They’re expensive for employers. Pension plans are typically funded entirely by employers, though not always. And the benefits are based on years of service, so companies with a lot of highly paid, long-time employees end up obligating themselves to many years of funding the plan.
Pension Plan Payouts
At retirement, employees in a pension plan receive a fixed payment each month. The benefits are for life, so there’s no risk of running out of money.
Some pension plans offer a spouse survivorship option, which generally pays a lower monthly amount to the retired employee but with the guarantee that upon their death, their spouse will continue to receive payments.
The amount a retiree receives each month is calculated based on the number of years the employee worked for a company and their salary. To receive the full pension benefit, an employee must work for a company for a specific number of years.
What’s important for someone considering a job with a pension? First, government salaries tend to be lower than the private sector. So you could become anchored to a job that pays less — but in exchange for retirement security, i.e., income for life.
Intro to 401(k) Plans
As pension plans have declined in popularity over the last several decades, 401(k) plans have skyrocketed. They allow employees and employers to invest funds toward the employee’s retirement.
Contributing to a 401(k)
For 2020 and 2021, employees can defer up to $19,500 of their salary pre-tax. Employees who are 50 or older can put in an additional $6,500. On top of employee contributions, many employers provide a match.
Many employers match 100% of employee contributions up to 3% of salary. So if you make $40,000 per year and contribute 3%, you’d put in $1,200 and your employer would kick in another $1,200.
Most people can’t afford to contribute the maximum amount to their 401(k). But you should try to contribute enough to get your employer match — otherwise you’re missing out on free money.
Most employer-sponsored 401(k) plans include access to online tools to help you determine how to invest. Target funds allow you to “set it and forget it” based on your risk tolerance, age and other factors.
Taxes and 401(k)s
Much like with IRAs, 401(k)s come with two tax options: a traditional 401(k) and a Roth 401(k).
If you contribute to a traditional 401(k), the money is “tax-deferred.” That means, if you contribute $10,000 to your 401(k) in 2020, you’ll pay no income taxes now on that $10,000. However, you will pay taxes on that money when you withdraw it during retirement.
With Roth 401(k) plans, you pay taxes now on the money you contribute, but it’s tax-free when you take it out when you’re retired.
Both types of 401(k)s carry a 10% penalty if you make early withdrawals (prior to turning 59 ½).
The key takeaway: Unlike with pension plans, there is no guarantee on the money in your 401(k). If the market tanks right before you withdraw it, you may not have time to make up the losses. But historically, the market goes up. As you work and earn more money in your career, you can accrue a big pot of money that goes with you when you leave your job.
Pension Plan vs. 401(k)
Here are the primary strengths and weaknesses of pension plans and 401(k)s:
Guaranteed Income: Pension Plans
A pension plan guarantees you income for life. You know exactly how much you will have each month. Talk about peace of mind in retirement.
Required Tenure: 401(k)s
Gone are the days when employees picked a company and stayed for 40 years. Workers nowadays tend to prefer to change jobs more frequently throughout their careers. Changing jobs is easier when you have a 401(k).
Low Stress: Pension Plans
Pension plan investments are set and managed by professionals — you don’t get any say. And because the plan guarantees the benefits, the money is typically invested very conservatively. A 401(k) is much more subject to fluctuations in the stock market.
Investment Flexibility: 401(k)s
With that risk comes opportunity. A 401(k) gives you more investment flexibility, and you can move your money into less risky investments as you get closer to retirement.
Timothy Moore is a market research editing and graphic design manager and a freelance writer. He has worked in the field since 2012 with publications like The Penny Hoarder, Debt.com, Ladders, WDW Magazine, Glassdoor and The News Wheel. He lives in Ohio with his fiance.