Pension vs. 401(k)
Pensions and 401(k)s are staples of employee retirement programs. However, each are very different from one another. Learn why this is and the benefits of each here.
During your working career, you may encounter employers with either the once-renowned pension or a 401(k) program. Both are tools that can help set you up financially for retirement. However, they have significant differences you should consider, such as how contributions work and when you can start withdrawing money.
In this article, we’ll explain how both pensions and 401(k)s work, as well as how they’re different. We’ll also answer common questions regarding the two retirement vehicles.
What Is a Pension?
Employers are the traditional sponsors of pension plans (or defined benefit plans). They offer them to attract and retain workers and to provide additional financial resources, in the form of regular payments, to long-time employees in retirement.
When you retire, your income depends on several factors, such as your age, salary, and tenure at the company. For instance, some companies take a percentage of the average of your last five years of salary, then multiply it by how long you’ve been working there. But this is just one example. The exact process can vary greatly depending on the organization.
Employers both shoulder investment risks and manage company programs on their employees’ behalf. You usually have some idea of how much a pension pays based on a pre-arranged agreement.
What Is a 401(k)?
A 401(k) is a savings account your employer manages intending to bolster your finances in retirement. These plans allow you to sock away a percentage of your pre-tax earnings from each paycheck. In many instances, employers match your contribution until you reach a specified limit. However, this depends on the company.
To start a 401(k), your employer must offer one. This is unlike an IRA, which you may start on your own at any time. As you begin contributing, the money is yours to invest and manage as you see fit. You assume the risks and can allocate funds into any kind of investment vehicle available within the plan. This could be assets such as the following:
Earnings within your 401(k) grow tax-deferred. This means that once you’re ready to withdraw funds, you’ll have to pay ordinary income tax. Also, when you make contributions, you’re doing so with pre-tax dollars which will reduce your taxable income each year. This all means that you have a chance to reduce or delay what you owe the government.
Typically, you’ll be able to withdraw money from your 401(k) at 59.5 years of age. Doing so beforehand will incur a penalty fee. Also, once you turn 73, the Internal Revenue Service (IRS) will require you to make minimum distributions from the account.
Difference Between the Two
While pension and 401(k) plans share some basic features, such as providing retirement income and being offered by your employer, there are many substantial differences between them. For instance, the former requires you to put full trust in your employer to manage investments. Below is a more specific breakdown of key features that the two programs share, as well as how they’re different, including a table to help you visually compare:
|Investment management||Employer-directed, you have no control.||Employee-directed|
|Contributions||Employer automatically takes amounts from your pay||Employee decides how much to contribute, and employer may match it|
|Vesting||Leaving job could cause you to lose some or all of your benefits.||Leaving job could cause you to lose any matched contributions your employer made.|
|Payout length||For life||Until funds run out|
|Income amount||Depends on your age, pre-retirement salary, and tenure||Depends on how much you decide to withdraw|
Structure and Funding
Pension plans are sponsored and funded entirely by your employer, who also covers all costs for operation and maintenance. How much you’ll end up making largely depends on your salary, plus other factors like your age and number of years at the company.
401(k) plans, however, are employee-funded apart from employer contribution matches. Any money you contribute to it from your paycheck reduces your tax burden because the amount is deducted from that year’s total income. You get to allocate funds to whatever investment options your plan offers. This means that you assume risk and any losses are on you.
Employees don’t make direct contributions to pension accounts, so there are also no limits. It’s up to your employer to make sure enough money is set aside to meet the predetermined retirement benefit. This means you’ll have no control over contribution amounts or investing options.
On the other hand, a 401(k) allows you to contribute as much of your paycheck as you desire up to an amount or limit defined by the IRS. Limits go up almost every year, so it’s smart to periodically check in with HR regularly to adjust. As of 2023, the contribution limit is $22,500 annually for a typical plan.
When it comes to how much income each provides, the differences can be stark. Pension plans provide a predefined amount of retirement income. How much you make post-career depends on factors like pre-retirement, how long you worked for the employer, and in some cases, income is based in part on your income at retirement.
A 401(k) makes no promises when it comes to how much wealth you generate in your working years. Your retirement funds consist entirely of how much you saved and how well your investments performed during this time. When you reach 59.5 years of age, you can begin withdrawing funds, convert the total into an annuity, or roll everything into an individual retirement account (IRA).
Vesting and Portability
Pension plans have vesting schedules. This entitles you to more and more of your benefits the longer you work at a firm. However, if you change jobs and leave your employer before you’re fully vested, you could lose some or all your benefits.
Conversely, 401(k)s only have vesting schedules for the employer match portion of your account. Any other funds that you’ve saved, including gains on your investments, are yours to keep no matter how long you work for a business. Should you change jobs, you can take your money with you and roll it into your new employer’s program or an IRA.
These retirement plans are benefits offered by employers and they’re far from universal. By “availability” we mean that you can get one of these plans if it’s offered by your employer. Otherwise, you’d have to rely on an IRA for retirement savings.
Pensions used to be the primary way employers provided retirement benefits to their workforce. However, these types of plans have declined in number in recent years as 401(k) accounts have gained traction, especially in the public sector. Even so, they still account for a significant portion of American retirement plans.
Which One Is Better for Retirement?
Both pensions and 401(k)s are useful financial vehicles that can help guarantee a certain amount of income at retirement. The former gives you less agency in running it but will ensure you receive payments for life. The other allows you to make investments on your own and control how much you contribute each year.
In simple terms, pensions are more of a sure thing in terms of income if you’re willing to stick with a company for your entire career. 401(k)s are a bit more open-ended, but you may not be able to extend it for life.
Overall, both can be exceptionally helpful for retirement, but they usually shouldn’t make up your entire income in retirement. A general rule of thumb is that you’ll need at least 70% of your pre-retirement income after your career. This is typically made up of the following types of sources:
- Employer benefit plans, such as a pension or 401(k)
- Social security
- Retirement savings accounts, such as an IRA
- Other investments and savings
If you’re unsure about how to properly plan for retirement, you should speak with a financial advisor. They can help you build a comprehensive strategy so that you can achieve a comfortable post-working life. You can find one using a free matching tool, which will match you with up to three vetted experts near you.
Frequently Asked Questions
Can I have both a pension and a 401(k)?
Yes, you can. However, you wouldn’t have both with one employer. Typically, you’ll have vested either one with a past company. Then, at your new job, you’ll receive a new benefit plan you can take advantage of.
Is a pension better than a 401(k)?
This is difficult to quantify. Both have benefits you should consider. First, pensions guarantee you income for life, however, they give you less control. With 401(k)s, you have more power over what you invest in and how much you can contribute, but this also means more risk.
What are the disadvantages of a pension?
Pensions give you little control over what happens with your money until you retire. Additionally, you’ll typically be unable to touch it before your career ends. And, if you leave your company before it vests, you could lose some or all of your withheld money.
This differs from a 401(k) which allows you much more control over your funds and investments. You also get to decide how much you contribute each year (up to the IRS limits). However, you also won’t receive a guaranteed income for the rest of your life. In that way, the two balance out a bit.
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