401(k)s vs pension plans: What's the difference?

Employers offer an array of benefits to attract and retain employees, and helping workers save for retirement is one of the most common perks. The two main types of retirement plans are 401(k)s and pension plans. While both can ensure you have a steady stream of income during your retirement years, these plans are very different in some fundamental ways. 

Read on to learn more about each type of plan and how they are different.

What is a 401(k)?

A 401(k) plan, also known as a defined contribution plan, allows employees to contribute a part of their paycheck (called a salary deferral) to an investment account, where it can grow in value. Employers generally match contributions to these accounts; for example, an employer may contribute 50 cents for every $1 you contribute. 

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There are several tax advantages to contributing to a 401(k). Your contributions are tax-deferred, meaning you do not pay taxes on the money in your 401(k) until after you begin withdrawing from the account after retirement (at which point withdrawals are taxed like normal income). This has the added benefit of reducing the amount of your income that is taxable. If your 401(k) contributions are enough to drop your income to a lower tax bracket, you are able to keep more of your income.

You can begin withdrawing money from your 401(k) account at the age of 59 1/2. While it’s possible to withdraw money from your 401(k) before 59 1/2, you will be charged a penalty (usually 10%). Withdrawals are required after the age of 73.

Employers typically hire external financial service institutions to manage the investments of employees' 401(k) accounts. Employees are provided with multiple investment options to choose from, usually made up of mutual funds and exchange-traded funds.

Investing your retirement savings means that your money can grow considerably, often much more than it would if it was simply accruing interest in a savings account in a bank. But it depends on the stock market’s performance — while a healthy market will provide you with financial gains, a poor market can lower the value of your 401(k).

401(k)s are offered by private-sector companies — that is, by for-profit businesses. A similar type of retirement account is offered by nonprofit organizations called a 403(b). It functions in much the same way as a 401(k), although there are some restrictions on investment options.

What is a pension plan?

With pension plans, also known as defined benefit plans, an employer promises a monthly benefit to the employee after retirement for the remainder of the employee’s life. The amount of the pension usually depends on salary, age and the number of years the employee worked for the employer.

While both employer and employee typically contribute to pension plans, employers bear the financial responsibility of the pension account.

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While pension plans were once commonplace, they’ve become increasingly rare. Only 15% of private-sector workers have access to defined benefit plans, according to the Bureau of Labor Statistics. They are more common for state and local government workers, with 86% of such employees having access. Many companies have found that sponsoring pension plans is economically burdensome and too complex to manage. 

How are 401(k)s and pension plans different?

With 401(k)s, employees are responsible for investing in their own retirements, whereas with pension plans, employers are responsible for providing their employees with specific, regular amounts after they retire. In essence, the main difference comes down to who bears the most risk in funding the employee’s retirement plan. 

Employees are responsible for contributing to their own 401(k), and they reap the reward or loss depending on the performance of their investments. While this places the burden of risk on the employee, it also gives them enormous control. Employees are free to choose how much they contribute to their 401(k)s (so long as they stay within the annual limit). They also have more control over investment options, which can range from conservative to aggressive. Many 401(k) holders opt to invest aggressively at the start of their careers, at a time when they can absorb more risk, and steadily adjust to a more conservative portfolio as they come closer to retirement.

With pensions, on the other hand, responsibility — and control — lies with the employer. Employers make decisions about how much to contribute to pension plans, which means there is always the risk that the company’s pension plans can go underfunded. Employees also do not have as much say, if any, as to how the pension plan funds are invested.

Pensions pay for life, no matter how long you might live, which may provide more peace of mind compared to 401(k)s, which can run out if the retiree lives long enough. However, that does not mean that pensions are always 100% safer. If the company fails, the company’s pension plan can disappear with it.

One high-profile example is the bankruptcy of United Airlines in 2005. The company defaulted on the $9 billion it owed in pensions, disrupting the lives of 120,000 employees and pensioners. While the airline did have some insurance coverage for the pension plans, they were not insured for the full amount, which meant that employees and pensioners had to take a significant hit.

Conclusion

Both 401(k)s and pension plans come with their own pros and cons. Pensions offer stability: employees who meet the requirements can retire knowing that they will get a regular check for the rest of their lives. However, 401(k)s offer employees more flexibility, choices and control.

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Employees are rarely in the position of being able to choose between the two. No matter what type of retirement plan you have, it's important to remember that it is just one component of preparing for retirement. You should be prepared for a range of eventualities to ensure that your life's third act is a great act.