Personal Finance

401(k) vs. Pension Plan: What’s the Difference?

401(k) and Pension Plans: An Overview

Both 401(k)s and pensions are employer-sponsored retirement plans. The most notable difference between the two is that a 401(k) is a defined contribution plan, while a pension is a defined benefit plan.

Defined contribution plans allow employees and employers (if they choose) to save and invest money for retirement, while defined benefit plans provide a specified retirement payment amount. These crucial differences determine whether an employer or employee takes investment risk.

Pensions have become less common, and although 401(k)s were originally designed as a complement to, not a replacement for, traditional pensions, they have had to make up for it. As of March 2021, 53% of private sector workers had access to a defined contribution plan, while only 3% had access to a defined benefit plan, and 12% had access to both. About a third, or 32%, have no access to an employer-sponsored retirement plan at all.

key takeaways

  • A 401(k) is a retirement plan that employees can participate in; employers can also provide matching contributions.
  • Through pension plans, employers fund and guarantee specific retirement benefits for each employee and take the risk of financial obligations.
  • Private sector pensions, once common, are rare and have been replaced by 401(k)s.
  • The shift to 401(k)s puts the burden of retirement saving and investing — and the risks involved — on employees.

401(k) plan

The primary source of funding for a 401(k) plan is employee contributions through pre-tax paycheck deductions. Contributions can go into a variety of investments—usually mutual funds, but may also offer stocks, bonds, other securities, and annuities. Any investment growth in a 401(k) is tax-free, and there is no cap on growth in a personal account.

Many employers offer contributions that match their 401(k) plans, which means they contribute additional funds to the employee account (up to a certain level) as long as the employee contributes themselves. For example, let’s say your employer provides 50% of your personal contributions to your 401(k), up to 6% of your salary. You earned $100,000 and contributed $6,000 (6%) to your 401(k), so your employer contributed an additional $3,000.

Unlike pensions, 401(k)s place investment and longevity risk on individual employees, requiring them to choose their own investments without guaranteed minimum or maximum benefits. Employees take the risk of misinvesting and saving over their lifespan.

There is a limit to how much you can contribute to your 401(k) each year. In 2021, employees will have an annual contribution limit of $19,500 and in 2022 the limit will be $20,500. Each year, those 50 or older can make additional contributions, up to $6,500 in 2021 and 2022.

pension plan

Employees have no control over pension plan investment decisions and do not take investment risks. Instead, employers contribute to portfolios managed by investment professionals. In some cases, employees may also contribute, which may be required or voluntary.

In turn, sponsors promise to provide retirees with lifetime monthly income. This amount is usually determined by the number of years the employee has worked, the final average salary based on the employee’s last three to five years of service, and a percentage multiplier (usually 2%). Pensions must vest, which means employees are eligible for the full amount. Vesting can happen immediately or after a set number of years, usually five to seven years.

Guaranteed income comes with a caveat: Benefits could be reduced if the company’s portfolio underperforms or if the company declares bankruptcy or faces other problems. However, almost all private pensions are insured by pension benefit guarantee companies and employers pay regular premiums, so employee pensions are generally protected. Ultimately, pension plans pose much less market risk to individual employees than 401(k) plans.

Although they are rare in the private sector, pension schemes are still somewhat common in the public sector – especially government jobs.

Pensions vs. 401(k)s: Which is Better?

While both plans have their pros and cons, a pension is generally considered a better option than a 401(k) because all the investment and management risk is with your employer, while guaranteeing you a fixed income for life. However, a 401(k) does offer some benefits.

A 401(k) can be more actively managed, and you can control growth, which can be bigger than a pension fund where you can’t control growth. It can start earning money immediately, while pensions typically take five to seven years to vest.

A 401(k) is also more portable; you can transfer it from one employer to another by transferring it into a new 401(k) at a new job. You can also transfer it to an individual retirement account (IRA). If you change jobs, the pension will remain with the employer providing the pension. You have to keep track of it, and when you’re ready to retire, you have to apply for a pension before you can get paid.

Advisor Insights

Ali Cowen, CFP
Korving & Company LLC, Suffolk, Virginia.

A 401(k), also known as a defined contribution plan, requires you as a pensioner to contribute to your savings and make investment decisions for the funds in the plan. So you can control how much you put into the plan, but not how much you can take out of it in retirement, depending on the market value of the invested assets at that time.

Pension plans, on the other hand, are often referred to as defined benefit plans, and the pension plan sponsor or your employer oversees investment management and guarantees a certain amount of income when you retire.

Because of this enormous responsibility, many employers choose to terminate their defined benefit pension plans and replace them with a 401(k) plan.

Can pension plans go up?

If it’s not insured with Pension Benefit Guaranty Corporation, in theory if a company goes bankrupt, it can. Fortunately, most private pensions are insured, so while payments may be reduced in the event of a financial catastrophe, pensioners are protected.

Can I receive my pension early?

Generally, the answer is no. You must wait until the retirement age specified in your pension plan. However, according to the Consumer Financial Protection Bureau, some unscrupulous operators have come up with the idea of ​​a “superannuation advance”. To get some ready cash, future pensioners can use some or all of their pension payments that they haven’t yet received as collateral. It just drains your retirement fund, and these deals often come with high fees and interest rates. If you have a military pension, this offer is actually illegal.

Can I get an early payment from my 401(k)?

In most cases, if you withdraw money from your 401(k) before age 59½, you will be charged an early withdrawal fee of 10% (and tax on the amount withdrawn). The IRS does list some exceptions to the rule on its website. They vary depending on the kind of retirement plan in question.

bottom line

Your employer is more likely to offer a 401(k) in its benefit package than a pension. If you work for a company that still offers a pension plan, your advantage is a guaranteed amount of monthly income in retirement, while the investment and longevity risks are borne by the plan provider. If you work for a company that offers a 401(k), you are solely responsible for your contributions and choice of investments.

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