Pension

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

There are significant differences between a pension and a 401(k). Pensions are known as a defined benefit plan. Under a defined benefit plan the employee receives monthly monetary compensation from their employer once they retire. This benefit is typically based on a calculation that takes into account the number of years of service the employee provided as well as their wages earned.[1]

In contrast to a pension plan, a 401(k) is known as a defined-contribution plan. Under a defined-contribution plan, the employee, employer, or both contribute to the employee’s defined contribution account. Under a 401(k), the employee can place a limited amount of their pre-tax income into their account. Employers may match these contributions.[2] The current contribution limit for a 401(k) account is $18,500 per year, or $24,500 if you are over the age of 50 due to the catch-up contribution provision.[3]

The most significant difference between these two types of retirement plans is that a pension provides a defined monthly benefit for the employee for the rest of their life after they retire. In contrast to this, an employee with a 401(k) only receives the amount of money left in their 401(k) account at the time of retirement. Another difference is that a 401(k) account can be influenced by market conditions, while a pension provides a static benefit regardless of market conditions.[4]

The Disappearing Pension Plan

Pension plans have largely been eliminated from the private sector as one of the options for retirement benefits. The responsibility of saving for retirement has been shifted from the employer to the employee. Most pension plans today are offered by public sector employers, with only 5% of private sector employers still relying on defined benefit plans.[5] One of the largest examples is the Federal Employees Retirement System (FERS), which covers federal civilian employees who were hired after January 1st, 1987.[6] Many local and municipal government entities also offer pensions, such as the San Diego County Employees Retirement Association (SDCERA).[7]

Factors to Consider With Pension Plans

The employer has the responsibility of choosing how a pension plan is invested, not the employee. This liability is coupled with the fact the eligible employees are guaranteed a certain benefit once they retire. The issue with this is that it is a liability that many companies are required to honor. Many public pension funds are underfunded, creating a worrisome situation for eligible employees. While not all pension funds face this issue, it is still worth considering when creating a retirement plan.  

In order to maximize the benefit of your pension funds, it is necessary to consider some key factors that may influence the health of your retirement. Among these are which annuity option you should choose, whether you should take a lump sum payout at retirement, and how interest rates impact that lump sum payout.

Which Annuity Option is Best?

There are a number of annuity options that pension plans offer. Some of the most common are a fixed period annuity, where regular payments are made to the employee for a fixed period of time. Single life annuities pay the recipient at regular intervals until they die and are often the default annuity option for public sector pensions. Joint and survivor annuities give the option to pay an annuity to the primary recipient until their death, then pay a spouse or dependent at regular intervals after the primary recipient has died. There are downsides to annuity options, including the fact that inflation will steadily chip away at the real income that you receive from your pension.[8]

Lump-Sum Payments

Some pension plans give the employee the option of taking a lump-sum payment when they retire. This money can be taken as a cash payment or can be transferred to an IRA. Rolling the lump sum payment over to an IRA maintains the tax deferment on the funds. Lump sum payments can be advantageous if you would like more control over investing your retirement funds, and to guard against inflation.