One of the biggest trends in the retirement plan industry over the past few decades has been the shift from traditional defined benefit pension plans to defined contribution plans like 401(k)s. Employers contribute to pension plans, while employees contribute to 401(k)s. Learn more about the differences between these two options.
What's the Difference Between a Pension Plan and a 401(k)?
|Employer contributes funds||Employee contributes funds; employer may match|
|Employer decides how to invest funds||Employee decides how to invest funds|
|Guarantees if the fund is terminated or mismanaged||Participants receive funds if the plan is terminated|
|Guaranteed income||No income guarantee|
A pension plan is an employer-sponsored plan where employee benefits are calculated using a formula that looks at factors such as length of employment and salary history. With pension plans, your employer contributes money to the plan while you are working.
Participants contribute to a 401(k). Employers may match employee contributions, but they aren't required to. If your employer matches contributions, the decision to participate is an easy one.
Consider matching dollars a bonus you get every pay period. Try to contribute at least as much to your employer-sponsored retirement plan as you need to get the maximum employer match.
With a pension plan, the plan sponsor decides how the pension funds are invested.
With a 401(k), you determine how the funds are invested. You typically have several investment options to choose from. One popular trend among retirement plans is to provide a one-stop-shop approach to diversifying investments through target-date funds. Your 401(k) plan sponsor may also offer professional investment guidance.
If you work for an employer that offers a pension, it is important to recognize they can choose to terminate the plan. In the case that your pension plan is terminated, your accrued benefit usually becomes frozen. In this scenario, you will receive benefits earned up to that point, but you will no longer accumulate any additional service credits.
Pension plans have been mismanaged in the past and unable to pay out all of the promised benefits for participants. If the pension plan was covered by the Pension Benefit Guaranty Corporation (PBGC), some benefits are protected for pension plan participants.
Employers can also terminate 401(k) plans. If a plan is terminated, all accrued benefits are vested, which means they fully belong to you. Employers are required to distribute assets as soon as it's feasible, and you can roll over the distributed funds to another qualified plan like an IRA.
Pension plans provide guaranteed income, and all of the investment risk is placed on the plan sponsor. While traditional pension plans have consistently declined in popularity over recent years, they are the most common example of a defined-benefit plan.
The formula a pension uses is generally based on a combination of the following factors:
- Your years of service with the company offering the pension
- Your age
- Your compensation
With a 401(k), your retirement income depends on your contributions, your employer match (if available), and the performance of your investments.
Other Characteristics of 401(k) Plans
401(k)s limit the amount you can contribute in a year. In 2020 and 2021, you can contribute up to $19,500 plus an additional $6,500 catch-up contribution if you are age 50 or older. If your contributions are made with pre-tax dollars, you could cut your final tax bill for the year by hundreds or thousands of dollars.
Your money continues to grow sheltered from taxes until you withdraw funds. You can withdraw funds without an early withdrawal penalty if you become disabled, reach age 59 1/2, or experience financial hardship. You're required to take a distribution after you reach age 72.
Roth 401(k)s allow you to contribute after-tax dollars that be withdrawn tax-free after age 59 1/2 as long as you’ve had the account for at least 5 years. Choosing whether it makes sense for you to receive the tax savings now or later is a big part of the pre-tax vs. Roth 401(k) decision.
The Bottom Line
The advantage of a pension plan is it provides guaranteed income. Fewer companies offer pension plans compared to previous generations. This means the burden of saving for retirement falls on you as an individual. As a result, you must figure out how to save enough to create your own pension-like income in retirement.
To make sure you're on the right track, run a basic retirement calculation at least once per year. A variety of different retirement calculators exist these days to help you run a simple retirement calculation to see if you are on the right track.