A pension plan has become exceedingly rare, or at least that’s the conventional wisdom. But that doesn’t mean pensions are not still an important retirement planning tool for many people. While it’s true that few private sector employers offer pension benefits for new hires, they are still common for people who work in the public sector. Many older people also have some pension benefits, perhaps from a previous employer. So, although pensions aren’t available to everyone, they are still an important part of the retirement planning mix for millions of Americans.
Whether you have a pension, a 401(k) plan, or a combination of the two, you may be wondering which is better. The answer is it depends.
The Difference Between Pensions and 401(k) Plans
What separates a pension plan from a 401(k) plan? A pension is a defined benefit retirement plan. Your employer contributes money throughout your working years in a pot with all other employees’ money. The money is then invested on behalf of you and your co- workers. When you retire, you receive a predetermined monthly benefit based on your length of service, salary, and age. Your benefit is guaranteed, but you don’t have any control over how the money is invested.
With a defined contribution plan, like a 401(k) plan, you (and your employer if they offer matching contributions) set aside money in a special account. You can then invest that money in options available in the plan. Unlike a pension, the amount you receive when you retire depends on the amount you save and the investment returns you receive.
Pros and Cons: Pensions
At first glance, pensions seem superior to defined contribution plans. After all, you get a guaranteed benefit that lasts for the rest of your life after you stop working. A pension eliminates the risk of outliving your money or losing all your savings because of a market crash or an investing mistake. Overall, pensions also have slightly better returns over time than 401(k) plans.
But pensions have their downsides too. One of the biggest is that you can’t control the investments. That means that if you’re a savvy or aggressive investor, you could be missing out on possible gains. Another drawback? If you leave your employer before a certain time (called your vesting period), you lose access to all or a portion of your benefit. Finally, if your employer runs into financial distress or goes out of business, your benefit may be far less than you anticipated.
Pros and Cons: 401(k) Plans
Employers love 401(k) plans since they take the responsibility for managing employees’ retirement off of the employer and put it onto the workers. Many employees like 401(k) plans too, since they can control how much they save for retirement and how it is invested. And the money you contribute is yours — you won’t lose it if you change jobs (although you may lose matching contributions, depending on how long you’ve worked for your employer) or face the possibility of reduced benefits if your employer goes bankrupt. Finally, you can pass on any money left in your 401(k) plan to your heirs. That’s not the case with a pension, where the benefits end after the pensioner or the pensioner’s spouse dies.
But 401(k) plans have their disadvantages as well. First, you need to be motivated enough to set aside money from your paycheck — money you could be spending today — for retirement. Many people struggle with this, either putting off saving or not saving enough. Another problem? Many people don’t take enough risk with their retirement savings. If you stick with cash or low-interest bonds, your returns likely won’t be high enough to generate the income you need in retirement.
Defined benefit and defined contribution plans each have their pros and cons. Whatever type of retirement plan you have access to, it’s essential to understand how it works and what your responsibilities and options are.