401(k) vs. Pension Plan: An Overview
A 401(k) and a pension are both employer-sponsored retirement plans. The most significant difference between the two is that a 401(k) is a defined-contribution plan, and a pension is a defined-benefit plan.
A defined-contribution plan allows employees and employers (if they choose) to contribute and invest funds to save for retirement, while a defined-benefit plan provides a specified payment amount in retirement. These crucial differences determine whether the employer or employee bears the investment risks.
Pensions have become less common, and 401(k)s have had to pick up the slack, despite having been designed originally as a supplement for traditional pensions rather than as a replacement. As of March 2021, 53% of private industry workers had access to defined-contribution plans, while only 3% had access to defined-benefit plans, and 12% had access to both. About one-third, or 32%, had no access at all to an employer-sponsored retirement plan.
- A 401(k) is a retirement plan to which employees can contribute; employers may also make matching contributions.
- With a pension plan, employers fund and guarantee a specific retirement benefit for each employee and assume the risk of the financial obligation.
- Once common, pensions in the private sector are rare and have been replaced by 401(k)s.
- The shift to 401(k)s has placed the burden of saving and investing for retirement—and the risk involved—on employees.
A 401(k) plan is primarily funded through employee contributions via pretax paycheck deductions. Contributed money can be placed into various investments—typically mutual funds, though stocks, bonds, other securities, and annuities may also be available. Any investment growth in a 401(k) occurs tax-free, and there is no cap on the growth of an individual account.
Many employers offer matching contributions with their 401(k) plans, meaning they contribute additional money to an employee account (up to a certain level) whenever the employee makes their own contributions. For example, assume your employer offers a 50% match of your individual contributions to your 401(k) up to 6% of your salary. You earn $100,000 and contribute $6,000 (6%) to your 401(k), so your employer contributes an additional $3,000.
Unlike pensions, 401(k)s place the investment and longevity risk on individual employees, requiring them to choose their own investments with no guaranteed minimum or maximum benefits. Employees assume the risk of both not investing well and outliving their savings.
There's a limit to how much you can contribute to a 401(k) each year. In 2021, the annual contribution limit for an employee is $19,500, and for 2022, the limit is $20,500. In each year, those aged 50 or older can make a catch-up contribution, which is $6,500 for 2021 and 2022.
Employees do not have control of investment decisions with a pension plan, and they do not assume the investment risk. Instead, contributions are made by the employer to an investment portfolio that is managed by an investment professional. In some cases, employees may also make contributions, which can be either required or voluntary.
The sponsor, in turn, promises to provide a certain monthly income to retired employees for life. This amount is usually determined by the number of years an employee has worked, a final average salary based on the last three to five years of the employee’s service, and a percentage multiplier, typically 2%. The pension must be vested, meaning that the employee is eligible to receive the full amount. Vesting can happen immediately or after a set number of years, often five to seven.
The guaranteed income comes with a caveat: If the company’s portfolio performs poorly or the company declares bankruptcy or faces other problems, benefits may be reduced. However, almost all private pensions are insured by the Pension Benefit Guaranty Corporation, with employers paying regular premiums, so employee pensions are often protected. Ultimately, pension plans present individual employees with significantly less market risk than 401(k) plans.
Though they are rare in the private sector, pension plans are still somewhat common in the public sector—for government jobs, in particular.
Pension vs. 401(k): Which Is Better?
Though there are pros and cons to both plans, pensions are generally considered better than 401(k)s because all the investment and management risk is on your employer, while you are guaranteed a set income for life. However, a 401(k) does offer some upsides.
A 401(k) can be more aggressively managed, and you control the growth, which can be greater than that of a pension fund, whose growth you don’t control. It can start earning money immediately, while a pension usually takes five to seven years before you are vested.
A 401(k) is also more portable; you can take it from one employer to another by rolling it over into a new 401(k) at your new job. You can also roll it over into an individual retirement account (IRA). A pension stays with the employer who provides it if you switch jobs. You must keep track of it, and when you are ready to retire, you have to apply for the pension before you can get your payments.
Arie Korving, CFP
Korving & Company LLC, Suffolk, Va.
A 401(k) is also referred to as a defined-contribution plan, which requires you, the pensioner, to contribute your savings and make investment decisions for the money in the plan. You thus have control over how much you put into the plan but not how much you can get out of it when you retire, which would depend on the market value of those invested assets at the time.
On the other hand, a pension plan is commonly known as a defined-benefit plan, whereby the pension plan sponsor or your employer oversees the investment management and guarantees a certain amount of income when you retire.
As a result of this enormous responsibility, many employers have opted to discontinue defined-benefit pension plans and replace them with 401(k) plans.
Can a Pension Plan Go Belly Up?
If it is not insured with the Pension Benefit Guaranty Corporation, it theoretically could if a company goes bankrupt. Fortunately, most private pensions are insured, so though payments might possibly be reduced in the event of a financial calamity, the pensioner is protected.
Can I Take My Pension Early?
Generally, the answer is no. You must wait until the retirement age specified in the pension plan. However, according to the Consumer Financial Protection Bureau, some unscrupulous operators have come up with the idea of a “pension advance.” In order to get some ready cash, future pensioners can use as collateral some or all of their as-yet-unreceived pension payments. This only eats into your retirement fund, and the offers usually come attached to high fees and interest rates. If you have a military pension, the offer is actually illegal.
Can I Get Early Payments From My 401(k)?
In most cases, if you make a withdrawal from your 401(k) before age 59½, you will have to pay a 10% early withdrawal fee (as well as pay taxes on the amount withdrawn). The Internal Revenue Service does have some exceptions to this rule listed on its website. They vary depending on the kind of retirement plan in question.
The Bottom Line
Your employer is much more likely to offer a 401(k) than a pension in its benefits package. If you work for a company that still offers a pension plan, you have the advantage of a guarantee of a given amount of monthly income in retirement, with investment and longevity risk placed on the plan provider. If you work for a company that offers a 401(k), you’ll need to take on the responsibility of contributing and choosing investments on your own.