401(k) vs. Pension Plan: An Overview
401(k)s and pensions share several similarities: to start, they're both employer-sponsored retirement plans that promise tax advantages as well as future financial security. 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.
In the U.S., pensions are still available for many public and government jobs, but have largely disappeared from the private sector, where they've been replaced by 401(k)s.
Key Takeaways
- A 401(k) is a long-term savings plan funded by deductions from employee paychecks. Some employers match these contributions.
- A pension plan is primarily funded by the employer. Employees may be allowed or required to contribute.
- A retiring employee will have control over and responsibility for the money in their 401(k).
- A retiring employee who has a pension will begin receiving a regular, fixed payment for life.
- Most employees would prefer to have a pension over a 401(k), because a pension provides a guaranteed income in retirement. However, pensions are more rare than 401(k)s.
- Both types of plans have tax advantages and tax rules that must be followed.
Defined Contribution Plan vs. Defined Benefit Plan
A 401(k) is classified as a defined contribution plan while a pension is a defined benefit plan.
A defined contribution plan allows employees and employers (if they choose) to contribute funds regularly to a long-term account. The employee chooses how to invest the money from a selection provided by the employer. Both the employer and the employee get tax breaks on their contributions. When the employee retires, the total amount in the account is theirs.
A defined benefit plan also grows over the years with contributions from the employer and employee. The employer generally pools all contributions to be professionally invested and managed. After retiring, the employee will receive a set payment from this fund for life. The payment is based on factors such as length of service and final salary.
Who Bears the Risk?
A crucial difference between a 401(k) and a pension plan is in who bears the risk.
A 401(k) is turned over to the retiring employee, who takes on the rights and responsibilities of managing the balance of the account. If the retiree spends all the money, or if the investments lose value, it's that person's problem alone.
A pension is paid out from a fund retained by the employer. If all of its retirees live to age 120, or the fund experiences investment losses, it's the company's problem.
Who Has a Pension?
The 401(k) was originally intended to be a supplement for traditional pensions, rather than as a replacement. It's rare to have both today. Pensions are disappearing from the private sector.
As of March 2023, about 67% of private sector workers in the U.S. had defined contribution plans, while only 15% reported access to defined benefit plans. This is in stark contrast to state and local government workers. Also as of March 2023, 86% of state and local government workers reported having access to defined benefit plans while only 39% had defined contribution plans.
401(k) Plans
A 401(k) plan is funded primarily through regular employee contributions via paycheck deductions, up to an annual limit set by the Internal Revenue Service (IRS). Those who choose a traditional 401(k) plan get an immediate tax break, as their contributions are deducted from their gross income for the year. Those who choose a Roth plan get no immediate deduction but will enjoy a tax break down the road when they withdraw the money.
Contributed money can be placed into various investments chosen by the employer. These are typically mutual funds although stocks, bonds, and annuities may also be available. Any investment growth in a 401(k) occurs tax-deferred until you make a withdrawal.
Many employers offer matching contributions with their 401(k) plans, meaning they contribute additional money to an employee account up to a certain level.
For example, your employer may offer a 50% match of your contributions to your 401(k), up to 6% of your salary. If you earn $100,000 and contribute $6,000 (6%) to your 401(k), your employer would contribute $3,000.
Unlike pensions, 401(k)s place the investment and longevity risk on individual employees, requiring them to choose their own investments with no guaranteed minimum or maximum benefits.
Employees assume the risk of outliving their savings or experiencing losses in a market downturn.
Pros
Protection under federal law (ERISA). This protection does not protect against investment losses
Matching funds (varying by employer, including some that do not match)
High annual contribution limit
Free investment advice (from the company and its fund provider)
Loans on 401(k) balance in case of emergency
Tax benefits for pre-tax (traditional) or after-tax (Roth) contributions
Cons
Limited investment options (depending on the plan provider)
Often higher fees than other self-managed investment accounts
Tax penalties on early withdrawals
Payout lasts only until the money runs out
There's a limit to how much you can contribute to a 401(k) each year. The contribution limit is $23,000 in the 2024 tax year. Those age 50 or older can also make a catch-up contribution up to $7,500. For 2023, the limit is $22,500, and the catch-up contribution limit is $7,500.
Pension Plans
Employees do not make any investment decisions about a pension plan, and they do not assume the investment risk.
Instead, contributions by the employer are paid into a fund that is managed by an investment professional. In some cases, employees may also make contributions, which may be required or voluntary. Still, the primary source of the money is typically the employer.
The employer promises to provide a certain monthly income to each retired employee for life. This amount is usually determined by the number of years an employee has worked, a final average salary based on the last three to five years of the employee’s service, and a percentage multiplier, typically 2%.
The pension must be vested, meaning that the employee is eligible to receive the full amount only after staying on the job for a number of years, often five to seven.
The main tax advantage is that you will not pay capital gains taxes on any portion of your pension, although you will owe income taxes.
The guaranteed income comes with a caveat: If the company’s portfolio performs poorly or the company declares bankruptcy or faces other problems, benefits may be reduced. However, almost all private pensions are insured by the Pension Benefit Guaranty Corporation. Employers paying regular premiums, which protects their employees' pensions.
Ultimately, pension plans present individual employees with significantly less market risk than 401(k) plans.
Pros
Pension funds compound returns
Primarily employer-funded with possible employee contributions
Guaranteed income in retirement
Burden of investing and money management is on the employer and not the employee
Easier to plan, as you know what your monthly retirement benefit will be
The plan payout is for life
Cons
Inaccessible until you're close to retirement age
Lack of control, as the money is managed by your employer and pension provider
Risk of company bankruptcy resulting in reduced pension benefits
Employer retains control over the money until the employee retires
Though they are rare in the private sector, pension plans are still very common for government jobs.
Pension vs. 401(k): Which Is Better?
There are pros and cons to both plans, but pensions are generally considered better than 401(k)s because they guarantee an income for life.
A 401(k) can be more aggressively managed by the individual, which could create more growth than is likely from a pension fund. Then again, investment losses are also possible.
The earnings on employee contributions to a 401(k) are yours immediately, while a pension usually takes five to seven years to vest. (Many 401(k)s have a vesting schedule for employer-contributed funds.)
Also, a 401(k) is portable. You can take the account from one employer to another by rolling it over into a new 401(k) at your new job. You can also roll it over into an individual retirement account (IRA).
A pension stays with the employer who provides it, even if you switch jobs. You must keep track of it, and when you are ready to retire, you have to apply to begin receiving your payments.
Can a Pension Plan Go Bankrupt?
A pension plan can collapse due to bankruptcy, mismanagement of funds, or catastrophic investment losses. Fortunately, most private pensions are insured through the Pension Benefit Guaranty Corporation. Payments might be reduced in the event of a financial calamity, but the pensioner has some protection.
Federal law requires that pension money be kept separate from company assets, so the company's performance after you retire should not affect your payments.
Can I Take My Pension Early?
The answer is generally no. You must wait until the retirement age specified in the pension plan.
Some unscrupulous operators pitch a bad deal called a pension advance. These offers usually come with high fees and interest rates, and they should be avoided. (They are illegal if they involve a military pension.)
Can I Get Early Payments From My 401(k)?
In most cases, if you make a withdrawal from your 401(k) before age 59½, you will have to pay a 10% early withdrawal fee (as well as pay income taxes on the amount withdrawn). The IRS does have fairly generous exceptions to this rule: they're called hardship withdrawals. Your company may also allow you to take a loan against your 401(k) assets and pay it back over time.
Is a Pension Better Than a 401(k) Plan?
A pension plan is better for those who are interested in securing a fixed, stable income throughout their retirement. There is also less risk involved, as it is overseen by your company. Investors who want more control over their retirement plan, plus the tax breaks, might prefer a 401(k). That said, most investors would prefer a pension.
Can I Have Both a Pension and 401(k)?
Yes, you can have both a pension plan and a 401(k) plan at the same time. It's more likely to have only one available through your current employer, but you might have a pension plan through a previous employer and a 401(k) at your current job.
This is certainly a good situation to be in. You can contribute to the 401(k) knowing that you already have a separate retirement income stream committed through your pension.
The Bottom Line
If you're working in the private sector, your employer is much more likely to offer a 401(k) than a pension in its benefits package. With a 401(k), you can make your own decisions on investing and watch your retirement fund grow. However, you lack the guaranteed income in retirement that a pension would provide.
If you work in the public sector or for a company that offers a pension plan, you have the advantage of a guaranteed monthly income in retirement, with the investment and longevity risk placed on the plan provider.
