Pension vs 401(k): Is one superior?

After starting a new job, you’ll probably need to decide if participating in an employer-sponsored retirement plan is right for you. Depending on the employer, they could offer either a pension or a 401(k), but rarely both.

It is key to understand the differences between and the benefits of each of these types of retirement plans so you can make sure you’re tracking accurately toward your retirement goals.

How do you compare a pension vs. a 401(k)?

While you are likely limited by what your employer offers, perhaps a previous employer offered one type of retirement plan and a new employer is offering the other. Even if you’ve only ever been offered a pension or a 401(k), understanding the benefits and drawbacks of each one can help you plan your retirement accordingly.

Both pensions and 401(k)s are employer-sponsored retirement plans intended to fund your retirement costs and potentially offer you tax savings. In order to take advantage, you may need to follow specific tax rules and guidelines to remain in compliance.

You might hear financial professionals refer to a pension as a defined benefit plan. This is a plan that grows over time as both the employer and employee contribute. Traditionally, these funds are pooled, invested, and managed by financial professionals. Your retirement payments will come out of this pool of funds.

After retirement, you will begin to receive a set payment for the rest of your life. Many factors, including your final salary, determine the amount you will receive.

In contrast, professionals refer to a 401(k) as a defined contribution plan. This type of plan will typically grow over time. The employee contributes to a long-term account at regular intervals. Your employer may or may not choose to match a percentage of your contribution.

Typically, you are allowed to choose how much of your salary to invest in the account. You will receive a tax break on all funds you contribute to your 401(k), not needing to pay income taxes on those funds until you withdraw money.

Upon retirement, you will typically gain access to all the funds in your 401(k) account as a single lump sum, which you can then use to create your own retirement income stream.

Below, we’ll explore the benefits and drawbacks of both pensions and 401(k) plans.

Most retirees agree that the greatest benefit of a pension plan is access to a guaranteed stream of income. If your employer remains in good financial health, there is very little risk to that income stream. For many, this peace of mind is all they need to confidently choose a pension plan.

Likewise, you will receive pension payments as long as you live, which means there is no risk of outliving your savings.

Finally, pension plans are based on employer contributions. Thus, the final payout is less reliant on individual contributions, which is not the case with a 401(k).

Pension plans tend to be very straightforward, which may be a benefit for some people. Ultimately, however, there are limited investment options, less choice, and less flexibility.

According to a Pew Research survey,¹ about 2.5% of Americans change employers each year, and that figure is growing. If you change jobs before retirement, your benefits may not be fully transferrable.

Remember, your pension is dependent on your employer's financial health. You should always do your research before committing to a plan or accepting the offer of a new job.

One of the biggest benefits of a 401(k) is that you get to decide where and how aggressively to invest your money. If you make wise decisions, you may see significant growth, which can serve you well during retirement.

Furthermore, your 401(k) comes with similar tax benefits to pensions but with added portability. Whether or not you switch employers, your funds are fully portable. Essentially, you determine your own level of risk.

Since your 401(k) is dependent on investments, there is generally always some risk involved. The more aggressively you invest your money, the greater the odds may be of losing funds. Likewise, market fluctuations can impact your 401(k) even if you choose fairly safe, lower-risk investment opportunities.

With that said, individuals with some financial knowledge tend to be more successful. Many people choose to work with financial advisors, which is an additional commitment. You need a base level of self-discipline to grow your bottom line.

Finally, your retirement income depends entirely on your contributions and investment returns. There is no guarantee that you will achieve your retirement savings goals.

If given the choice between a 401(k) or a pension, consider the following factors:

• Your risk tolerance: How comfortable are you with investment risk? If you are offered a pension, it tends to have less risk of loss especially if the employer is in good financial health. If you are offered a 401(k), you can generally adjust your investments based on risk tolerance.
• Your career stability: How long do you plan to remain in your current role? Are there opportunities for growth, or will your goals require you to find employment elsewhere? If your employer has a pension and you are planning on retiring while working for them, this could be a good plan for retirement. If, like many Americans, you are only offered a 401(k), you could benefit from the portability of this plan if you’re changing jobs.
• Your financial goals: Setting retirement goals can help you determine the funds you need to see them come to fruition. Regardless of which plan you are offered, strategize your savings to ensure you can support your desired lifestyle.

Ultimately, there is no single superior retirement plan. When deciding to participate in a pension plan or a 401(k), do your research, weigh your options, and consider consulting with a financial professional to ensure either plan meets your financial goals.

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

Sources:

¹ Pew Research