Choosing a pension vs 401(k) plan can be tricky. Make sure you ask the right questions.
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Parsing the benefits of a pension vs 401(k) plan can be challenging, as these income-replacement vehicles are two very different animals.
A pension is a regular, predictable, and guaranteed monthly income stream funded solely by your employer. In contrast, with a 401(k), the amount of money you amass to pay for retirement expenses is determined by the contributions you (and your employer) make to the account, how aggressively you invest, and the market returns you earn.
Since 401(k) dollars are typically invested in stocks, bonds, and other financial assets, your account balance will fluctuate as market prices rise and fall. There’s also no guarantee that your money won’t run out.
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Pension plans, though, aren’t as common today in the private sector as they were during your grandparents’ careers. Fewer companies offer pensions due to their rising and unpredictable costs. In fact, only 15% of private industry workers had access to a pension in 2022, a study by the U.S. Bureau of Labor Statistics found. In contrast, two out of every three workers said they had access to a 401(k)s.
Here are the key differences every retirement saver and future retiree needs to know.
A pension plan, often referred to as a defined benefit plan, is a company-funded plan that does all the saving for you and pays you a guaranteed monthly check. Pensions typically send you these payments for life when you retire (or a lump sum if you choose). How much you receive is based on how much you earned, how old you are, and how many years you worked at the company.
Pension income is taxed at your regular income tax rate.
“For retirees, a pension is quite nice because they know at what age it will start and what the monthly dollar amount will be,” said Nicole Birkett-Brunkhorst, formerly of U.S. Bank Private Wealth Management and now a senior wealth adviser at 1834. “So, from an income-replacement standpoint, pensions offer a lot of stability because it’s a guaranteed source of income.”
All that predictability comes at a price. Since your employer — not you — funds the pension benefit, you cannot control how much money your company sets aside for you or how your pension dollars will be invested and grow over time.
In contrast, with a 401(k) retirement savings plan, or defined contribution plan, the onus is on you — the employee — to set aside money for your Golden Years via regular payroll contributions. You must also make investment decisions yourself, designating how the savings will be assigned to different investments within the 401(k) account.
“Since the employee is contributing to their own retirement account, they have more skin in the game,” said Birkett-Brunkhorst. “But employees have a lot more control over their 401(K) than they do their pension. They get to decide how they want their dollars invested.
Most employers will also make monthly deposits to your 401(k) account via so-called “matching” contributions. These deposits match either all or a portion of your own contributions, up to a percentage of your annual salary, often between 3% and 6%. Matching contributions are one of the best perks of 401(k)s, sometimes referred to as "free money."
401(k)s also come with tax benefits that pensions don’t offer. A traditional 401(k), which you fund with pre-tax dollars, for example, lowers your taxable income in the year you make the contribution. A Roth 401(k), which you fund with earnings that have already been taxed, allows you to make withdrawals tax-free.
In 2024, employees can contribute up to $23,000 in a 401(k) plan and those aged 50 or older can also contribute an additional $7,500 in so-called “catch-up” contributions.
Here are some other important things you need to know about pensions and 401(k)s.
Pension payments commence once you retire, but you won’t receive your full benefit until you reach your retirement age, typically 65. You’ll receive a reduced benefit if you start taking benefits before your full retirement age.
With a 401(k), in most cases, you can start withdrawing your money penalty-free at age 59 ½.
With a pension, if you opt for the monthly check rather than a lump sum payout, you’ll know exactly how much you will receive based on when you start taking payouts. Your pension check, though, will be larger if you start taking benefits once you reach your full retirement age. And the longer you live, the greater your total benefit will be.
In contrast, the amount of income you can generate for retirement with a 401(k) is variable, as your account balance is impacted by market conditions, the size of your account balance and types of investments you own, and your withdrawal strategy.
“The growth of your investment account is going to play a huge part in what your end value of your 401(k) plan will be,” said Billy Voyles, founder and president of Fundamental Wealth Designs.
In most cases, pension payments will last a lifetime. You’ll get pension checks until you die.
With a 401(k), however, you can continue taking withdrawals from your account until the money runs out. In short, there is no guarantee that you won’t outlive your money.
Unless you’ve set up your pension with a so-called survivor benefit, your pension dies with you. However, if a survivor benefit is in place, your spouse will continue to receive pension benefits, but at a lower monthly benefit.
When you pass, the balance in your 401(k) account passes on to your heirs, based on your beneficiary designations.
With a pension, it might make sense to take a lump sum pension payout and rollover the money to an IRA rather than signing up for the monthly check for life. Why? It allows you to leave behind money to heirs.
“By taking a lump sum, you are taking control of that sum of money from your employer so you can create a legacy for your heirs,” said Rob Leiphart, vice president of financial planning for RB Capital Management.
401(k) holders who switch jobs or opt to retire early can either keep their 401(k) in their existing company’s plan or roll a 401(k) over to an IRA, which offers a plethora of investment options.
The most significant risk of a pension is that your company goes out of business or declares bankruptcy. However, there is some protection for employees of a bankrupt company. The dollars used to fund company pensions are typically segregated in a separate account, or trust, which lowers the risk of not getting paid. In addition, most companies insure their pension plans via the Pension Benefit Guarantee Corporation (PBGC), which guarantees payments to pension holders.
401(k)s also come with risks, similar to any other investment. These accounts are vulnerable to financial market declines, subpar returns and account holders’ low savings rates.
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