Business Insider – July 6, 2020
Retirement savings is an alphabet soup of options.
There are 401(k)s, 403(b)s, IRAs, SEPs, pensions, and so many more plans available to working Americans saving up to retire one day.
Two of the most well-known retirement plans — pensions and 401(k)s — are totally different, and whether you utilize one or the other, or both, during the course of your career largely depends on where you work.
Pension vs. 401(k): The major differences
Traditional pension plans are defined-benefit plans, while 401(k)s are defined-contribution plans. If you’re not well-versed in tax law or financial jargon, that probably doesn’t mean much to you, but it’s a big distinction.
A pension plan simply means a retirement plan is employer-funded, while a 401(k) is a profit-sharing plan wherein employees, and sometimes employers, contribute to retirement savings.
A pension provides a specific benefit to an employee when they retire, usually determined by a formula that considers the employee’s age, years of service, and compensation. At retirement, a 401(k) is worth only employee contributions and investment gains, with the occasional employer contribution.
If you work for a company that offers a pension plan, the company will handle your retirement fund and determine how to invest the money. You might also defer a portion of your paycheck to your pension, but you usually don’t have to. If you work for a company that offers a 401(k) plan, the onus to save, invest, and eventually draw an income is on you.
Employers assume the risk with a pension plan and must guarantee retirement income to an employee. Because they’re expensive to maintain, many private employers have phased out pension plans and replaced them with 401(k)s or other profit-sharing plans.
There are some pension plans that operate as a hybrid between defined-contribution and defined-benefit plans by combining the simplicity and relative flexibility of the former with the funding mechanism of the latter.
Is a pension better than a 401(k)?
A pension isn’t necessarily better than a 401(k). It may seem more advantageous on the surface — hey, you don’t have to save any of your own money to retire comfortably — but there are trade-offs.
An employee with a traditional pension plan doesn’t get to decide where their future retirement funds get invested today. They also can’t take loans or early withdrawals from the plan.
Someone with a 401(k) has full control over their investment choices and can fit them into their overall investment strategy, and has the power to draw on their savings before retirement if needed. If you don’t manage risk well and your interest in financial markets is low, you might think a pension plan sounds like a better deal. The opposite could be true, too.
Also, traditional pensions aren’t portable. If you leave your job before your pension vests, you’ll never see the money. With a 401(k), you get to keep your contributions no matter when you leave.
Can you have both a pension and a 401(k)?
You can have a pension plan and a 401(k) at the same time, but usually not from the same company. If you left a job that offered a pension plan and you worked there long enough to be vested, then the company has a promise to pay you benefits upon retirement.
You won’t be able to manage your investments in that pension plan — it’s still the duty of your former employer — but you can contribute to 401(k) at your new job, if it’s offered.
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