Pension vs. 401(k)


The following is a common question when it comes to retirement: What is the difference between a pension plan and a 401(k)?The following is a common question when it comes to retirement: What is the difference between a pension plan and a 401(k)?

The simple answer is that a pension plan is a “defined benefit” plan, which guarantees a given amount of monthly income, and thus predictability, in retirement; while a 401(k) is a “defined contribution” plan, in which individuals choose their own retirement investments, including the amount contributed.

However, there are also many other differences to explore:

Funding Source

One of the biggest differences is who pays for these plans. As mentioned, individuals get to choose the amount they place in their 401(k) plan because it is their money, which also means they assume the investment risk. On the other hand, a traditional pension plan is fully funded by the employer, meaning employees do not have control of their investment decisions, including which stocks, bonds and mutual funds their money is invested in.

Availability

For the above reason, your employer is much more likely to offer a 401(k) than a pension as a benefit. “Pensions have become less popular with the rise of defined contribution plans. This is because pensions are both more expensive and more risky to employers than a 401(k) plan,” an Investopedia article explains. The article states that “401(k) plans also allow smaller employers, which otherwise might not have had the money to set up a pension plan, to provide retirement benefits to prospective workers.”

Tax Control

The source of the funds within the plan also leads to who controls that money, which is important for a number of reasons besides just who assumes the risk of the investments. Because 401(k)s are primarily funded through employees’ contributions via pretax paycheck deductions, you get to choose if you want to delay withdrawals, take out only a portion of your savings or go for other options to keep your tax deferred. Meanwhile, a pension always counts toward your income tax.

Transferability Among Jobs

Because they are indeed yours, your contributions to a tax-deferred 401(k) are vested immediately, meaning you can take them anywhere, to any job; meanwhile, if you have a pension and then change employers, you might have to give up the opportunity to get guaranteed monthly payments for life or start all over again on a new pension clock.

Emergency Access

According to David Ning of U.S. News & World Report, taking money from your retirement account is never recommended; but if you must, in certain emergency situations, you’ll want the flexibility of a 401(k) over a pension. “Roth IRA contributions can be withdrawn tax free after five years, and 401(k) balances can be taken out as a loan,” Ning explained. “There is no such luck with pensions. Even worse, you might lose all your benefits if an emergency requires you to quit your job before you have qualified for any benefits.”

Regardless of the differences among plans, the most important thing is to at least have a plan and not head into retirement with no strategy and no savings.

 

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