Pension vs. 401(k): Which Retirement Plan Is Right For You?

Written by JD Esajian

Key Takeaways

When you’re saving for retirement, it’s essential to have a plan and start saving as soon as possible. These days, most companies offer a retirement plan you can sign up for after 60 or 90 days. That said, there are different types of retirement accounts, and most companies will only offer one of them. Whether it’s your first job or your tenth, it’s important to understand what’s on offer.

The most popular types of retirement accounts are pensions and 401(k) plans. Both of these accounts are designed to provide you with a stream of income during your retirement. However, there are important differences between the two, and they have different pros and cons.

Let’s compare a pension vs. 401(k) and determine which one is right for you.

What Is A Pension?

A pension is a retirement fund that provides you with a guaranteed monthly payment upon your retirement. Depending on the plan, this could be a fixed dollar amount, or it could be based on your salary and years of employment. For example, many pensions will base your pension payments on your average pay during your last few years of employment.

Pension benefits begin when you retire and continue to pay out over the rest of your life. Some plans provide a spousal benefit even after your death. In most cases, you’ll have to work for your employer for a certain number of years before you’re “vested,” which means you’re eligible to receive a pension.

The nice thing about a pension is that your employer takes on all the risks. They manage the pension fund, so you don’t have to worry about allocating your investments. And because the company guarantees the payments, you’ll get your full pension payment regardless of market conditions.

How Does A Pension Work?

Like other benefits, employers typically provide pensions as a way to attract new employees. Here are some of the basics you need to understand:

Pension plans are employer-funded: Instead of setting aside a portion of your own income for retirement, your employer does it for you. This is normally the case, although some pensions are funded by employee contributions.
Payments depend on tenure and salary: In most cases, employees will get larger pension payments the longer they’ve been with the company. Higher-paid employees will normally receive a larger pension than lower-paid ones.
Payments begin upon retirement: Starting from the day you retire, you’ll receive regular payments for the rest of your life. Most pension benefits are capped at 100% of your average salary for your three highest-paid consecutive years of employment. In addition, there’s a maximum annual payment of $245,000, although that number is adjusted annually for cost of living.
Most pensions aren’t portable: If you leave your employer before you retire, you won’t be able to transfer your pension to another company, or to a private account. If you’re vested, you can still collect your pension eventually, but not until you retire. If you’re not vested, the money is effectively lost. Government jobs work a bit differently; in most cases, you can transfer your pension from one government agency to another, but not to a private retirement account.
Pensions are less common than they used to be: Nowadays, people switch jobs more often than they used to. For this reason, most employers offer portable retirement plans like a 401(k).
Your money is almost 100% safe: Most pension plans are insured by the Pension Benefit Guaranty Corporation (PBGC), which is a federal agency. If the company goes out of business or declares bankruptcy, the PBGC will make the pension payments instead.

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401k vs pension

What Is A 401(k)?

A 401(k) plan is what’s called a “defined contribution” plan. You decide in advance what percentage of your income to contribute, and that money is automatically taken out of your paycheck and put into the account. Most employers will match your contributions up to a certain percentage. By taking advantage of this matching contribution, you’re effectively getting a free raise.

With a 401(k), you choose your own investments and have control over your own money. However, your account will fluctuate with the market over time and can go down as well as up.

Most 401(k) contributions are not considered taxable income. Instead, you’re taxed on any withdrawals you take after retirement. That said, you can also invest money in a Roth 401(k). This is a special type of 401(k) where you make contributions out of your after-tax income. Because you already paid taxes, your withdrawals are not taxed. And as a bonus, you pay no taxes on any account growth.

401(k) contributions are capped at $20,500 per year, per individual. However, individuals 50 and over can contribute an additional $6,500 per year in the form of catch-up payments.

Pension vs. 401(k): Key Differences

A pension and 401(k) are two of the most well-known retirement accounts available today. While they both offer the benefit of securing retirement income, there are several key differences to keep in mind. Read through the following list to get a better look at a pension plan vs 401(k):

Contributions: A pension plan is completely funded by employers, while 401(k) plans rely heavily on employee contributions. For this reason, pensions are thought to be highly desirable, despite requiring a minimum number of years at the job.
Account Control: Account holders can choose how to invest and withdraw the funds of a 401(k), while pensions are completely controlled by your employer. This allows 401(k) account holders to choose how their funds are invested.
Length of Benefits: 401(k) plans only last as long as the money in the account lasts. Unfortunately, it is not uncommon for individuals to fail to save enough for retirement. On the other hand, pensions are guaranteed for the rest of someone’s life.
Duration of employment: With a pension plan, you can’t receive any payments until you’re fully vested, which can take as long as seven years. With a 401(k), you can start contributing right away and have immediate access to those funds.
Level of control: A 401(k) gives you control over your money, and how your savings are invested. You can choose between mutual funds, stocks, index funds, and other investments. On the other hand, a pension fund is controlled entirely by the company. They decide how the money is managed.
Portability: A 401(k) can travel with you from employer to employer, and the funds can be rolled over from one 401(k) to another without penalty. You can even roll a 401(k) account into an IRA. A pension plan, on the other hand, is not portable. If you leave your employer, you’ll have to keep your information current with their pension plan, and apply once you’ve reached retirement age. Worse, if you leave before your pension is vested, you won’t get anything at all.
Plan stability: Pensions are considerably more stable than 401(k)s. Because your employer has guaranteed your payments, you can rely on receiving them under any circumstances. A 401(k) plan, on the other hand, floats with the market. If the market goes down, so will your balance.
Growth potential: On the flip side, a 401(k) has a lot more potential for growth. Because the stock market trends upwards over time, your money can multiply. On the other hand, pension plans are never going to pay more than the fixed amount.

Can You Have Both A Pension And A 401(k)?

You can have both a pension and a 401(k) if you have worked for an employer that provides each of these retirement accounts. For example, you could work at a private company that offers a 401(k) after one year of employment. Let’s say you work at the company for a year and open the 401(k). You then decide to leave your job for a government position. In this position you are offered a pension after working for 40 years — at this point, you would be eligible for a pension while still having your previous 401(k) account available.

Opening more than one retirement account is generally thought to be a beneficial strategy. Although, it can be difficult to obtain both a pension and a 401(k) because they are both employer-sponsored. If you have a pension or 401(k) and are interested in bolstering your retirement savings, consider looking into an IRA as another option. You can combine as many retirement saving strategies as you want, just make sure to choose the right options for your needs.

Pension Vs. 401(k): Which Is The Better Plan?

Deciding whether a pension or 401(k) plan is better will depend on what your goals are for both your career and retirement. Most workers do not have a choice in the retirement plan their employer provides, however, this information can be useful if you are deciding between job offers or perhaps starting a business yourself. Here are a few things to consider as you weigh the benefits of a pension vs 401(k):

Pensions Risk Being Underfunded: Employers control how much to add to a pension fund, which in some cases can lead to pensions being underfunded. This risk is especially high during periods of economic downturn, as most pensions are provided by governmental agencies. With a 401(k), the responsibility to plan ahead is entirely in your hands.
401(k)s Require Investment Choices: When you open a 401(k), you will be directly responsible for how that money is invested. Employers will typically appoint a financial advisor to help guide your investment decisions, and you will be allowed to grow your retirement in mutual funds, index funds, and more. This allows you to increase your retirement savings, but it also puts you in charge of the risk management associated with those investment choices.
Pensions Stay At The Company: Pensions can be a great way to guarantee retirement income, but that comes with a tradeoff. You have to work at an organization for a minimum number of years to be eligible for a pension. Those benefits do not transfer to your new role if you leave the position early. As “job hopping” becomes increasingly common, 401(k)s are thought to be a better alternative as these accounts can move with an employee.
401(k) Plans Protect Against Company Failure: When it comes to private companies, 401(k) plans are generally safer in the event a company goes out of business. This is because employers do not have any control over 401(k) plans, and you would be able to keep your account if the company ceased business operations. If a company providing pensions were to go bankrupt, all of the employees would, unfortunately, lose their retirement benefits. At this point, they would have to go through the Pension Benefit Guaranty Corporation (PBGC) to determine eligibility for benefits.

How To Make A 401(k) More Like A Pension Plan

With pensions becoming rarer and rarer, it can be hard to find a job that offers one. Thankfully, there are some tricks you can use to make your 401(k) as reliable as a pension.

Invest As Early As Possible

Your retirement account will grow over time as the market trends upwards. But to take advantage of this, you need to invest early. The longer you wait, the less time your money will have to grow. By investing earlier, you harness the power of compound growth, and your account will be that much larger.

Invest the Annual Maximum

The more you invest, the better your account will perform in the long run. If at all possible, contribute the annual maximum. If you can’t afford that, at least set aside enough to get the full employer match. For example, if your employer will match up to 3% of your paycheck, try to save at least 3%.

Open An Individual Retirement Account (IRA)

If you want to save even more, you can invest in an IRA or a Roth IRA. These accounts allow you to save an additional $6,000 per year towards retirement, or $7,000 per year if you’re age 50 or older.

Think About Purchasing An Annuity

An annuity is an insurance product that pays a guaranteed annual amount upon retirement and pays a death benefit to your next of kin. Much like a life insurance policy, it pays to sign up when you’re young. As you get older, you’ll have to contribute a lot more money to get the same annual payment.

Pension Vs. 401(k) FAQs

Before we wrap up, let’s talk about some of the most frequently asked questions regarding pension plans and 401(k)s.

Can You Withdraw From Your Pension Early?

In most cases, you cannot receive pension money until you reach the retirement age laid out in the pension plan. That said, some companies offer what’s called a “pension advance,” which is a loan that uses your future pension payments as collateral. Keep in mind that these advances charge steep interest rates and high fees. In fact, it’s actually illegal to take an advance against a military pension.

Can You Get Early Payments From Your 401(k)?

Yes, you can. The money is yours, and you can access it any time you need to. However, if you take a withdrawal before age 59½, you’ll pay an early withdrawal fee of 10%. This is in addition to any taxes, so it’s generally not advisable to withdraw retirement funding except for true emergencies.

Can Pension Plans Go Belly Up?

In most cases, no. As long as the pension is insured with the PBGC, you’ll receive your payments no matter what. For this reason, it’s important to verify that your prospective employer’s pension fund is insured.

Summary

Nowadays, 401(k) plans are far more common than pensions. Even so, many companies still offer pensions, so it’s important to understand the differences between the two. Remember, a retirement plan is part of your compensation, just like your salary and other benefits. And much like the rest of your compensation, you need to know what you’re getting before you accept the job. Like many forms of investment, deciding between a pension vs. 401(k) comes down to your personal goals.

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