When you’re ready to retire, you’ll want to have more than Social Security to pay the bills. Those benefits typically only provide enough money to replace about 40% of average earnings. Covering the rest is up to you.
“There are two types of ways you can pay for retirement (through the workplace),” according to Tonya Manning, wealth practice leader and chief actuary for Buck, a firm that provides pension and employee benefit consulting, among other services.
You could have a defined benefit plan, which is a traditional pension, 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.
To understand the basics of each account, including the benefits, disadvantages and differences between a pension plan vs. a 401(k), use this guide.
[READ: Jobs That Still Offer Traditional Pensions]
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 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.
“You can often refer to a pension as similar to Social Security,” says Tim McGrath, a certified financial planner and managing partner of Chicago-based Riverpoint Wealth Management. Like Social Security, pensions provide regular, predictable payments for life.
Employers are largely responsible for funding pensions, but employees may be asked to make contributions toward this benefit. Once retired, 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.
Plans may also offer a spouse survivorship option. If selected, workers will get a lower monthly payment but a spouse will be entitled to continue receiving benefits after the worker dies. 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.
[Read: What Is a Good Monthly Retirement Income?]
A Disappearing Retirement Benefit
While workers and retirees may like pensions, they have fallen out of favor with employers.
“Very few public sector employers are offering pensions nowadays,” says Todd Feder, senior retirement plan consultant with Girard, a Univest Wealth division.
That’s because while pensions are predictable for employees, they represent an unknown and rising expense for employers. A company promises that in exchange for years of service, it will financially support a worker throughout his or her entire retirement. That has become an expensive promise, especially now that the baby boomer generation has hit retirement age.
The number of defined benefit plans dropped quickly in the 1990s, and that corresponds with an increase in defined contribution plans such as 401(k) accounts, according to data from the U.S. Department of Labor. In 2020, there were 46,577 defined benefit pension plans offered in the U.S., down from a peak of 172,648 in 1986.
Among the pension plans offered today, the vast majority are for government employees. Only 15% of private industry workers had access to a defined benefit pension plan in March 2022, the Bureau of Labor Statistics says. That compares to 86% of those employed by state and local governments.
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.
“With a 401(k), they are going to have a pot of money available to them at retirement,” Feder says. How big that pot is depends on how much money an employee saves during their working years.
In 2023, employees can contribute up to $22,500 to a 401(k) plan. Those age 50 and older can make $7,500 in catch-up contributions for a total annual contribution of $30,000.
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, although this may be subject to vesting requirements.
“We’ve created a system in which everyone is self-funding,” Manning says. When it comes time to retire, “You get to decide how you take out your money and when.”
Traditional vs. Roth Accounts
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. Any money taken out of an account prior to age 59 1/2 may be subject to a 10% penalty. Once a retiree reaches age 73, he or she must begin making required minimum distributions or pay a penalty equal to 25% of the distribution amount.
Roth 401(k) plans, on the other hand, do not provide a deduction for contributions but they can be withdrawn tax-free in retirement. Like traditional 401(k) accounts, there may be a 10% 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.
[See: 10 Steps to Max Out Your IRA]
Pension vs. 401(k): Which Is Best?
The major differences between pensions and 401(k) plans can be summed up as follows:
— Pensions are primarily funded by employers, while 401(k) plans are primarily funded by employees.
— Pension investments are controlled by employers, while 401(k) investments are controlled by employees.
— Pensions offer guaranteed income for life, while 401(k) benefits can be depleted and depend on an individual’s investment and withdrawal decisions.
— Pension benefits do not pass to heirs unless there is a spouse survivorship provision, while money left in a 401(k) account can be distributed to beneficiaries other than a spouse.
All this means there is a lot for workers to like about pension plans. They provide lifetime income for retirees, and if the market drops, workers don’t have to worry about their monthly payments declining.
However, with a 401(k), 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.
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 advisors to help guide investment elections.
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.
When it comes to comparing a pension plan vs. a 401(k), pensions are often seen as the clear winner. However, younger workers aren’t likely to benefit from these retirement plans. “There are very, very few individuals starting in a job with a pension,” McGrath says.
Fortunately, the smart use of a 401(k) plan can provide benefits that make for a comfortable retirement. To make the most of your company-sponsored retirement plan, start saving early, maximize your employer’s match and watch your balance grow.
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What’s the Difference Between a Pension Plan and a 401(k)? originally appeared on usnews.com
Update 08/24/23: This story was published at an earlier date and has been updated with new information.
