Pensions vs 401(k)s

Whether you’re just entering the workforce or you’ve been employed for a number of years, it’s never too late to think about how you’ll pay for your retirement. Your future income is based on what you’ve paid into the system, so the decisions you make now will impact how you afford to keep your lifestyle without pinching pennies in your old age.

 You may be wondering if a pension is the same as a 401(k) retirement fund. They are not. These types of accounts are different from each other and have a unique set of requirements.

What Is a Pension Plan?

A pension plan is an employer-based benefit plan where the investment is made by the employer on behalf of the employee. Upon retirement, the employee will receive investment returns as a source of income. Employees can elect to be paid a lump sum, but typically they choose to receive regular payments.

In order to receive a pension, employees may be required to work a set number of years and reach a qualifying age before being eligible for retirement payments. These guaranteed payments, once established, will continue until the death of the employee. If the plan allows, they can even be passed along to a beneficiary, including a spouse or child.

The amount of the pension is not a simple dollar figure. It is determined by the number of years you worked at your place of employment, your salary, and any extra requirements set by your employer. Some will indicate, for example, that you will receive 6% of your annual salary for the pension total, while others may have a more calculated method.

How Is a Pension Managed?

Pension funds are controlled by the employer, so the employee does not have any influence on how it is managed. Some consider this an advantage while others would like more say in how their money is invested. Any adjustments are made by the fund managers, and the employee doesn’t have to focus on market trends or adjusting investments based on their age. If you’re more inclined to research this area and want to be more involved, you might want to look into other retirement options.

What Is the Difference Between Retirement and Pension?

Most often, people retire after age 65 or once they’ve worked for 25 years or more. A pension is a fund used as income once you have retired from working. Employees invest in their pension while working, growing the fund until retirement.

What Is a 401(k)?

The most common type of retirement plan is the 401(k). With its primary funding sourced from employee contributions, the contributions on this account are payroll deductions taken pre-tax. There are many investment options, including stocks, bonds, exchange-traded funds, and mutual funds, depending on what your employer includes in its sponsored program. For this type of plan, you contribute a set amount of money from their paycheck. After retirement, you can withdraw your funds however you like.

The 401(k) account does have annual limits. Employees under age 50 can contribute up to $23,000 annually in 2024 ($22,500 in 2023). If they are 50 years of age or older, however, the total allowable contribution for the year is $30,500.

Most employers offer to contribute toward the 401(k) accounts of their employees. The employer’s contribution is typically a percentage of the employee’s contribution but could also be matched dollar for dollar. The company could require a set number of years, usually four or five, in order for the match to be fully vested and belong to the employee.

Since the 401(k) fund is tax-deferred, you will be lowering your taxable income and saving on your taxes each paycheck. You also have the potential of being in a lower tax bracket once you enter retirement. Retirement income needs are difficult to predict, as are tax rates in the future, so the guarantee of reduced rates is unrealistic for the future, so deferring current taxes is a better plan for the next few decades.

What Is the Difference Between a Pension Plan and a 401(k)?

The biggest difference between a pension plan and the 401(k) plan is that pension plans are considered defined benefit plans and 401(k)s are considered defined contribution plans. Company pension plans and 401(k) plans will have clearly established differences. You contribute a specific amount throughout your employment, and upon retirement, you can withdraw money as you desire. The pension, on the other hand, establishes guaranteed payments upon retirement and will continue those payments through death, however, the employee cannot provide any input on investment handling of the account.

The consistency of the pension payouts is great for planning, but the 401(k) plan uses employee contributions, employer matching, and market effects, both positive and negative, to stock your account. Once you begin receiving your pension benefits, you can count on the payments for the rest of your life in the same amount. Unlike the pension, there is no guarantee for future payments when your funds are invested in a 401(k). The 401(k) could easily lose money, which is another reason why a pension may be preferable.

If you don’t plan on staying with your employer long enough to become fully vested, and your employer struggles to keep the pension fund strong, a pension is not the best option for you. Furthermore, if you prefer to have more control over your retirement investments, opt for a 401(k). You can choose your investment profile and select pre-set options, or you can hand-pick stocks you’d like to invest in.

Whether you’re opting for the less hands-on pension account or you’re a market expert and like to choose your own investments in your 401(k) account, these retirement options will help keep you on track for a comfortable lifestyle once you’re old enough to retire from your place of employment. 

As an employer, you may be deciding which product to provide for your employees. For further information, reach out to the professionals at Human Interest.