Pensions once held the distinction of the most popular employer-sponsored retirement plan in the country. However, due to the much higher cost on employers, pensions have become significantly less popular, especially for non-government employees. In their place, more employers are offering 401(k)s. Typically employers will offer either a pension or a 401(k), but not both, so it’s unlikely you’ll ever have to choose between the two. However, odds are that you or someone close to you will enroll in one of these plans at some point in your career, so it’s helpful to understand how they’re similar and how they differ.
What Is a Pension Plan?
A pension plan is a defined benefit plan in which an employer sets money aside for an employee and invests it on the employee’s behalf. When the employee retires, she receives the return from that investment as retirement income. This can be in a lump sum, but it’s much more likely to be in regular payments. These payments are guaranteed to keep coming until the employee dies. They may even pass on to a surviving spouse or child, depending on the plan.
Your pension amount is determined by a few different factors, including your salary, the numbers of years you worked for your employer, and any special terms your employer set. Some employers specify a percentage of your salary as your pension amount, but others have different methodologies.
Employees with pensions have no say in the management of the funds. This can be both a benefit and a disadvantage. On one hand, you don’t have to think about choosing investments for your retirement. You also don’t have to worry about adjusting your asset allocation as you approach retirement.
On the other hand, your nest egg is in the hands of fund manager who might make mistakes. That’s probably not going to be an issue – in theory, your pension is guaranteed, regardless of investment performance. But a pension fund could struggle if its investments don’t pan out or there’s a recession. And it’s not unheard of for companies and even municipalities to go bankrupt and struggle to pay out benefits.
Before you’re guaranteed benefits, you have to work for your employer long enough for your benefits to “vest.” Vesting can happen all at once or it can occur in steps. Make sure you know your vesting schedule if you’re enrolled in a pension plan. It’s important to know if you’re walking away from a lot of money by leaving a job too early.
What Is a 401(k) Plan?
A 401(k) plan is the most well-known of all the defined contribution plans. With a defined contribution plan, you contribute a specific amount of money from your paycheck. You can then withdraw it during your retirement as you see fit.
As with a pension, you’ll need to work for a company that sponsors a 401(k) in order to gain access to one. One of the plan’s biggest upsides is that the contributions you make are tax-deferred. A portion of your salary drops directly into your 401(k) before it faces any income tax. It can then grow tax-free until you begin withdrawing after you retire.
Tax-deferred status brings two main benefits. First, you can lower your taxable income, which means you pay less in taxes. Second, you may be in a lower tax bracket in retirement than you are now if you have a lower income once you stop working. (Of course, it’s hard to predict your retirement income needs, and very hard to predict future tax rates, so there’s no guarantee that you’re better off deferring your tax bill.)
With a 401(k), you’re in charge of setting up your plan, choosing a portion of your paycheck to contribute and determining what fund or funds to invest in from the choices your plan offers. Another big benefit is that some employers match your contributions up to a certain amount. For instance, an employer may match 50% of contributions on up to 8% of your salary. If your salary is $100,000, this means that you can get as much as $4,000 in free (and tax-free) money if you contribute at least $8,000 per year. If your employer does this, you should do whatever is necessary to meet the threshold to “max out” your employer match. Failing to do so would effectively mean you’re turning away free money.
Pension vs. 401(k)
The most notable difference between these two retirement plans is that 401(k) plans are defined contribution plans, while pensions are defined benefit plans. With a 401(k), you contribute a set amount throughout your career, and can then withdraw money as you please once your retire. With a pension, you receive guaranteed payments after you retire and up until the day you die, but you have no role in the process at all before then.
If you receive pension benefits, you can rest easy knowing that you’ll keep receiving the same amount for the rest of your life. With a 401(k), the amount you have in retirement is dependent on how much you contributed while you were working (and how much it grew in the market). In other words, you could run out of money.
The guarantee of lifetime income means most people would prefer to have a pension. Of course, preferences and circumstances could change this calculus. Perhaps you prefer the increased control that comes with a 401(k). Perhaps you don’t think you’ll be with an employer long enough for your pension to vest. Or perhaps your employer has struggled to keep its pension fund solvent. In these circumstances, you might prefer a 401(k).
In any case, it’s likely that you won’t be in a position to choose between the two – an employer will offer one or the other, with private sector companies tending to offer 401(k)s and public employers tending to offer pensions.
Tips for a Successful Retirement
- A financial advisor can be a great partner in putting together a retirement plan. If you’d rather not go it alone, talking to a financial advisor could be a big help. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you have a 401(k), contribute as much as you can. At the very least you should max out any employer match, but if you can afford to, you can contribute up to $19,500 for the 2020 tax year. Here’s a guide to how much you should contribute to your 401(k). If you’re not sure how much you’ll need in retirement, our retirement calculator can give you an estimate.
Photo Credit: ©iStock.com/PeopleImages, ©iStock.com/TheCrimsonRibbon, ©iStock.com/AndreyPopov