Pension plans, which are funded by your employer, are increasingly being replaced by 401(k) plans, which are employee-funded. Learn how these plans work and what they mean for your retirement.
There are many different retirement plans that can help you save for a comfortable retirement. However, since all retirement planshave their own features and benefits, it's not always easy to know which one is which. That's why it's best to compare as many different plans as possible in order to make the right choice for you.
So what are pensions plans and 401(k)s, and what are the key differences between the two?
Pension plans are defined benefit plans that can offer a great deal of security, providing lifetime income throughout retirement. However, these plans are increasingly rare and mostly found in government agencies. Today, 401(k)s are the most prominent type of retirement plan for most private sector companies, offering employees an opportunity to save a portion of their income, tax-deferred, and investing it in one of many select program investments. Often, companies will match a portion of the employee’s 401(k) contributions. Read on for additional details and pros and cons of each type of plan.
What is a pension plan?
A pension plan (also referred to as a defined benefit plan) is a retirement account that is sponsored and funded by your employer. Retirement benefits are based on a formula that includes factors such as your salary, age, and the number of years you have worked for the company. For example, your pension benefit might be equal to 1% of your average salary for the last five years of employment, and then times your total years of service.Over the years, your employer makes contributions on your behalf and promises to make regular, predetermined payouts every month when you retire.
Pros
- Typically, pensions are a defined benefit program, which means that you will begin receiving income at the time of your retirement.
- In many pension programs, payout runs for life, providing a greater degree of security, no matter how long you live.
Cons
- Since the company is in control of the money, you won’t have a say in how it’s invested.
- If you change jobs, you may forfeit your right to your pension since the money is not portable as it is with a 401(k).
- If the company fails prior to your retirement, your pension may not be honored.
What is a 401(k) plan?
A 401k planis a retirement account that's made available to employees who wish to save for their retirement (provided their employer offers a plan). In this case, it's the employer that holds back a part of your salary (tax-deferred) and invests those dollars on your behalf. Some employers are even willing to match the contributionsmade by their employees with their own money. Since 401(k) plans are meant to encourage you to save for retirement, there are heavy tax penalties imposed for early withdrawals (before age 59½).
Pros
- With a 401(k) plan, you may choose from a list of available investments, giving you more control over how the money is invested.
- You may roll over your money if you change employersover time.
Cons
- Your contributions are invested in market securities, so there is some volatility associated with 401(k) plans.
- It’s possible to access the money and use it for emergencies or other uses prior to retirement, which may leave your retirement savings drained prior to retirement.
- A 401(k) is a defined contribution plan, so your account could be depleted during retirement.
Pension plan vs 401(k)
A pension plan is funded and controlled by the employer, while a 401(k) is primarily funded by the employee, who may choose from a list of offerings, how the money is invested. Some employers will match a portion of your 401(k) contributions. A 401(k) allows you some control over your fund contributions, while a pension plan does not. Pension plans guarantee a monthly check in retirement a 401(k) does not offer guarantees.However, 401(k)s are portable, meaning you can roll them over into another account should you change employers one or multiple times. Pensions may only be available if you stay with that company through retirement.
Pension plans have been in existence for a long time, while 401(k)s are now more common. In fact, the 401(k) will most likely be replacing pension plans altogether in the near future.1 However, there are still employers who offer both a pension plan and a 401(k) plan - if you're lucky enough to be in that fortunate situation.
1. http://www.ssa.gov/policy/docs/ssb/v69n3/v69n3p1.html
WEB.1332.03.15
FAQs
Pension plan vs 401(k)
Are pension and 401(k) the same thing? ›
Both are methods of funding employees' retirement costs with real tax savings for participants. The main differences: A pension guarantees the retiree a set payment for life. A 401(k) and similar plans, like the 403(b), accumulate cash until the employee retires and takes responsibility for managing the account.
Is a 401 a considered a pension? ›
A 401(a) is a defined contribution plan, where a pension is a defined benefit plan. With a pension, employees receive the benefit of a fixed monthly income in retirement; their employer pays them a fixed amount each month for the rest of their life.
What are the disadvantages of a pension plan account? ›
Employees Have No Control in Fund Management
Another disadvantage of a pension plan is that employees generally have no say in managing their pension fund. The investment decisions are made by the employer or the pension fund manager, and employees cannot change the investments or allocations.
How does pension work? ›
With the traditional pension plan, known as a defined-benefit plan, employers set aside funds in a pool of money that is invested. Employees who retire receive either a lump sum or guaranteed set monthly payments for life, regardless of investment performance.
Are pensions guaranteed for life? ›
Key Takeaways. Pension payments are made for the rest of a retiree's life. Lump-sum distributions allow individuals to spend or invest the money. People who take a lump sum may outlive their money, while traditional pension payments continue until death.
Do you pay taxes on a pension? ›
Taxes on Pension Income
You have to pay income tax on your pension and on withdrawals from any tax-deferred investments—such as traditional IRAs, 401(k)s, 403(b)s and similar retirement plans, and tax-deferred annuities—in the year you take the money. The taxes that are due reduce the amount you have left to spend.
Why did 401K replace pensions? ›
Why did 401k replace pensions? Employers made the switch from traditional pensions to 401(k) plans in order to transfer responsibility for retirement savings onto their employees and decrease long-term financial obligations, ultimately leading to increased overall profits.
Is my retirement considered a pension? ›
Pensions differ in that respect from employee-managed retirement plans (such as 401(k) plans) in which employees choose how much to save and how to invest. The term "pension" is not typically used to refer to such savings plans. The IRS provides additional information about the various types of retirement plans .
Do you pay into a pension? ›
A pension plan requires contributions by the employer and may allow additional contributions by the employee. The employee contributions are deducted from wages. The employer may also match a portion of the worker's annual contributions up to a specific percentage or dollar amount.
In most cases, pension payments will last a lifetime. You'll get pension checks until you die. With a 401(k), however, you can continue taking withdrawals from your account until the money runs out. In short, there is no guarantee that you won't outlive your money.
How risky is a pension? ›
While investing in a pension gives your money the potential to grow, it's important to be aware that investment always comes with risk and the value of your investment and any income from it may fall as well as rise and is not guaranteed.
Who pays out pension? ›
Pension plans are funded by contributions from employers and occasionally from employees. Public employee pension plans tend to be more generous than ones from private employers. Private pension plans are subject to federal regulation and eligible for coverage by the Pension Benefit Guaranty Corporation.
How many years does a pension last? ›
Pension benefits are typically a fixed monthly payment in retirement that is guaranteed for life. Some pension benefits grow with inflation. Other pension benefits can be passed on to a spouse or dependent. But pensions aren't the only financial route to guaranteed lifetime income after you retire.
Which is better, pension or social security? ›
Prioritizing a pension over Social Security can be attractive for several reasons. First, pensions often provide a more predictable and potentially higher income stream. The predictability of a fixed income from a pension can also be advantageous who prefer financial stability and want to plan their retirement budget.
What is average pension amount? ›
Average Monthly Retirement Income
According to data from the BLS, average 2022 incomes after taxes were as follows for older households: 65-74 years: $63,187 per year or $5,266 per month. 75 and older: $47,928 per year or $3,994 per month.
How do I know if I have a pension? ›
Contact your former employer
If you want to trace a workplace pension – a scheme arranged by a previous employer – your first point of contact should be the employer. However, if your employer provided access to a personal or stakeholder scheme, contact the pension provider if you know their details.
What is pension income? ›
A payment or series of payments made to you after you retire from work.
Why did 401k replace pensions? ›
Why did 401k replace pensions? Employers made the switch from traditional pensions to 401(k) plans in order to transfer responsibility for retirement savings onto their employees and decrease long-term financial obligations, ultimately leading to increased overall profits.
