When you’re ready to retire, you’ll want to have more than Social Security savings to pay the bills, which typically only provide enough money to replace about 40 percent of average earnings.
To live comfortably in retirement, you should have either a traditional pension plan or a defined contribution plan, like a 401(k) account. While both plans provide money in retirement, they are vastly different in how they are set up and administered. “Many Americans think a pension is better, but a 401(k) is just as good, if not better, if workers are educated and disciplined,” says Logan Howard, a certified public accountant based in Masontown, Pennsylvania.
To understand the basics of each payment plan, including the benefits, disadvantages and differences between a pension plan vs. a 401(k), use this guide.
What Is a Pension Plan?
As a workplace benefit, pensions give workers a monthly payment in retirement, as long as they have met certain eligibility criteria. Typically, companies will require that employees work a minimum number of years to receive a pension, and they must reach a certain age before getting a stream of retirement payments. The pension benefit is usually calculated with a formula that takes into account a person’s years of service and earnings.
Employers fund pensions entirely, and employees don’t have to make any contributions to gain this benefit. As a result, workers have limited control over how they receive their pension. Some companies give employees the choice of receiving their pension in a lump sum, but monthly payments are more common.
“Usually there is an option for a reduced monthly payout (in exchange) for spouse survivorship,” says James Sullivan, vice president of advisory firm Essex Financial in Essex, Connecticut. If selected, workers will get a lower monthly payment but a spouse will be entitled to continue receiving benefits after the worker dies. Keep in mind, it can be difficult, if not impossible, for a retiree to change this election, so workers should carefully consider their health and life expectancy as well as that of their spouse when deciding whether to opt into spouse survivorship, Sullivan cautions.
While pensions are a valuable and popular work benefit, they are also becoming scarce. “In most cases, the workers who would have a pension plan in this day and age would be government workers,” Howard says. Only 16 percent of Fortune 500 companies offered pensions to new hires in 2017, according to a study from global advisory and solutions firm Willis Towers Watson. Twenty years ago, nearly 60 percent of these large companies offered defined benefit pension plans to new employees.
The decline in pension availability is related to their high cost. “At the end of the day, a pension is a promise by an employer,” says Yanela Frias, senior vice president and head of investment and pension solutions at Prudential Retirement in Westwood, New Jersey. A company promises that in exchange for years of service, it will financially support a worker throughout his or her entire retirement.
However, that has turned into a pricey promise with public pensions scrambling to find an additional $4.4 trillion to fully fund their pension liabilities. That’s how much Moody’s Investor Service calculated public pensions were underfunded earlier this year. The cost of supporting retirees has far exceeded what was envisioned when plans were created, thanks in large part to today’s longer life spans.
While governments are grappling with how to pay for pensions for teachers and civil servants, private sector workers typically don’t have to worry about their pension being lost to underfunding. The Pension Benefit Guaranty Corporation, a government agency, insures the pensions of some 37 million private workers.
What Is a 401(k) Plan?
As companies have phased out pension plans, they have replaced them with 401(k) plans, which shift the responsibility of saving for retirement to workers. In 2019, employees can contribute up to $19,000 to a 401(k) plan. Those age 50 and older are entitled to make $6,000 in catch-up contributions, for a total annual contribution of $25,000.
Many employers make contributions to workers’ 401(k) accounts. However, employees may need to work a certain number of years to become vested and fully entitled to that money. What’s more, firms will often match a certain percentage of a worker’s contributions to the plan, though this may be subject to vesting requirements.
There are two versions of 401(k) plans and each offers its own tax benefits. Traditional 401(k) plans offer a tax deduction at the time contributions are made. Money grows in the account tax-deferred and then is subject to regular income taxes when withdrawn in retirement; the money taken out of an account prior to age 59 ½ may be subject to a 10 percent penalty. Once a retiree reaches age 70 ½, he or she must begin making required minimum distributions or pay a penalty equal to 50 percent of the distribution amount.
Roth 401(k) plans, on the other hand, do not provide a deduction for contributions, but can be withdrawn tax-free in retirement. Like traditional 401(k) accounts, there may be a 10 percent penalty on early withdrawals, but that only applies to investment gains. Since the contributions have already been taxed, there is no penalty for withdrawing a portion of the principal early. Unlike traditional accounts, Roth 401(k) plans have no required minimum distributions in retirement.
Pension vs. 401(k): Which Is best?
For some workers, there is a lot to like about pension plans. “With a pension, the employer bears all the risk,” Frias says. If the market drops, workers don’t have to worry about their monthly payments declining.
However, with a 401(k), “the employees bear the investment risk,” Howard says. If investments fail to perform as expected, it has a direct impact on a retiree’s nest egg. Employees are also given control over which funds within a company’s plan to place their money and that too can come with risks. “Sometimes, they are selecting the wrong investment,” Howard says.
For example, workers may be placing money in aggressive funds when they should be investing more conservatively or vice versa. To help workers make smart decisions, many 401(k) plan administrators offer educational tools or even access to financial planners to help guide investment elections. “Much more active engagement is required with a 401(k) plan,” Frias says.
Some might consider the time and effort needed to properly manage a 401(k) to be a negative, but Sullivan disagrees. “I think control of investments is a good thing,” he says. In short: It gives workers the chance to maximize their money in the long run if they make wise decisions.
Another significant difference between pension and 401(k) plans is transparency. While 401(k) plans make it easy for workers to see where their money is invested and how it is performing, there is no such option with a pension plan. In some cases, workers may even have to pay for a pension benefit calculation if they want to know how much to expect for their monthly payments in retirement.
When it comes to comparing a pension plan vs. a 401(k), it’s easy to think pensions are the clear winner. However, the smart use of a 401(k) plan can provide benefits that are more than adequate for retirement and perhaps even exceed what would be offered through a pension. To make the most out of your company-sponsored retirement plan, start saving early, maximize your employer’s match and watch your balance grow.