Pension vs. 401(k): Is One Better than the Other?

Pension plans have rapidly disappeared in the private sector over the past several decades. Just 15% of private-sector workers had access to defined benefit pension plans in 2021, according to the Congressional Research Service. As private employers phase out pension plans and replace them with 401(k) and similar plans, you might wonder which type of plan is better.

The answer isn’t so simple. Many employees prefer pension plans, and indeed, they may be better for a large cohort of people. But 401(k) plans come with their advantages, too. We’ll take a look at those as we break down how the two types of plans compare.

Pension vs. 401(k): Is one better?

Many employees prefer pensions because they offer a consistent, predictable income stream in retirement. With pensions, employees don’t have to assume the risks associated with a struggling stock market if their investments don’t perform as expected. Regardless of market conditions, employees with a pension receive the same amount.

However, 401(k) plans still have some benefits. One of the biggest is that they offer employees more control over their investments. As an employee with a 401(k), you can usually pick from a list of mutual funds, selecting funds that align with your goals. However, that does mean you assume the risks of a struggling market, and your retirement income could be less than expected.

	Pension	401(k)
How payouts are determined	Based on a formula that considers things such as employee salary and the number of years they worked for the company	Based on employee (and perhaps employer) contributions as well as market performance
How the account is funded	Mostly funded by the employer	Mostly funded by the employee (employers may match a % of contributions)
Who controls the investments	Mostly the employer	Mostly the employee
How long payouts last	For life	Until the account is depleted
Vesting period	Up to 10 years	Up to 6 years

Pension plans

Pensions are what is known as a defined benefit plan. With these plans, the employer, not the employee, contributes to an investment portfolio. An investment manager then manages the portfolio, and employees don’t have a say in the investments chosen.

With this type of plan, the employer assumes all of the risk. Regardless of market conditions, employees receive a certain payout, typically a monthly payment, in retirement. Those payouts continue until the end of the employee’s life unless they opt for a lump-sum payment.

Even if the market performs worse than expected, most pensions are insured by the Pension Benefit Guaranty Corporation. Employers pay premiums to the insurer in order to protect employee pensions in the event of poor market conditions.

The employee’s payout is usually determined by their years of service. In addition, their average salary over the past three years may be a factor, as well as a multiplier. There may also be a vesting period that employees must work for the employer before they can receive a pension. That period tends to last for five to seven years, though it can be immediate in some cases.

You’re typically not allowed to withdraw from your pension until you reach retirement age, and retirement age varies by plan.

401(k) plans

401(k) plans are what are known as defined contribution plans. With this type of plan, employees usually contribute a set amount of money each pay period via payroll deduction. In such cases, a certain percentage of each paycheck is withheld and directed into a 401(k).

These employee contributions tend to be pre-tax, which means the money is not taxed as it goes into the 401(k), and also grow tax-deferred. The money is taxed when it is withdrawn. The exception is the Roth 401(k), in which contributions are made with after-tax dollars, and withdrawals are tax-free.

Investment mix

Unlike a pension, employees usually have some degree of control over their 401(k) investments. Employers will offer a list of mutual funds in which employees can invest. If you don’t choose your investments, employers direct your money to a default investment, such as a money market fund or a target-date fund. However, you can usually choose your investments later.

Because employees can make their own investment decisions, there may be more growth potential for 401(k) plans in the long run. However, the burden is on the employee to do their own due diligence in researching and choosing investments.

Risk of loss

Another way in which 401(k) plans are different from pensions is they are not insured by the PBGC. Thus, the employee assumes the risk. If the market doesn’t perform well, they could end up with less money in retirement than expected. There’s no virtually guaranteed income as there is with a traditional pension plan.

Matching contributions

In many cases, employers offer matching contributions to 401(k) plans. For example, they might match 50% of your contributions up to 6% of your salary. For example, if your salary is $75,000, 6% would be $4,500. If you contribute that amount to your 401(k) in a year, the employer would contribute $2,250.

Portability

If you have a pension, you may not be able to take it with you if you decide to leave your job. With a 401(k), it is usually possible to do so. For example, you could decide to roll it into an IRA. You may also be able to roll it into your new employer’s 401(k).

The one way that 401(k) plans may be similar to pensions is both can have a vesting period. With a 401(k), if you leave your job before your account is fully vested, you can lose some or all of the employer’s matching contributions.

As with pension plans, the vesting period may last several years for 401(k) plans. However, 401(k) plans are more likely to start vesting immediately.

RMDs

If you have a 401(k), 403(b), or traditional IRA, you’re typically required to take a minimum amount out of your account starting at age 72. This is known as a required minimum distribution. Pensions don’t have an RMD requirement.

Make the most of your retirement savings

Saving for retirement is important, especially as pension plans have largely disappeared in the private sector. Fortunately, you can still have a financially secure retirement with proper planning and execution.

Contribute to an IRA

Contributing to an individual retirement account can have a lot of advantages. An IRA is a type of retirement savings account. These accounts have tax advantages, and if you open an IRA with an online broker, you have access to the full suite of investment options. This is in contrast to employer-sponsored 401(k) plans, which can be somewhat limited.

You can also open either a traditional IRA or a Roth IRA. Traditions IRAs are tax-deductible, which means you can deduct the contributions on your tax return. The money grows tax-free and is taxed as income when withdrawn. With a few exceptions, you can’t withdraw money from a traditional IRA before age 59 1/2 without incurring a 10% early withdrawal penalty.

The big difference with the Roth IRA is how they are taxed. You fund these accounts with after-tax dollars, and the money grows tax-free as it does for traditional IRAs. However, because they are funded with after-tax dollars, you pay no tax on withdrawals. For that same reason, you can withdraw earnings at any age as long as the account is at least five years old.

You can contribute up to $6,500 into an IRA ($7,500 if you’re age 50 or older) in 2023. In 2024, you can contribute up to $7,000 into an IRA ($8,000 if you’re age 50 or older). Note that there are income limits for contributing to a Roth IRA and for deducting your traditional IRA contributions.

Buy an annuity

An annuity could be a good way to supplement your retirement income, particularly if your employer doesn’t offer pensions. An annuity is an insurance product you can buy, either paying a lump sum or making payments over time.

There are different types of annuities, but fixed annuities can be quite similar to pensions. Once you buy the annuity, you receive regular payments from it either immediately or beginning at a certain point in the future. Fixed annuities pay the same amount every month, quarter, or year.

Another way in which annuities are similar to pensions is you don’t risk having lower payouts in the future. Annuities are offered by insurance companies, and the insurer assumes all of the risk associated with the account. However, that does make annuities expensive to administer, and payouts can be somewhat low (and fees somewhat high) as a result.

Max out your employer match

As mentioned previously, many employers offer matching contributions to employer-sponsored retirement plans. This may apply to 401(k) plans as well as other types of employer-sponsored retirement plans.

In the example mentioned in the previous section, your employer would contribute up to $2,250 to your 401(k) in the form of matching contributions. However, if you don’t contribute to your 401(k), you won’t receive that money. This is why you may hear that you are leaving money on the table if you don’t contribute up to the limit of your employer match.

Make catch-up contributions

Catch-up contributions are usually for those age 50 or older. IRAs, 401(k), and other kinds of retirement accounts may give you the option to make catch-up contributions. If you have the option, you may be able to contribute more beyond the normal contribution limit.

It’s a good idea to contribute as much as you can to your retirement, including catch-up contributions. These contributions probably won’t be met with employer matching, but because retirement accounts offer tax advantages, it’s still worth doing if you have the means.

Minimize fees

Some mutual funds, especially those that are actively managed, can have high fees. Some employers only offer high-fee mutual funds with their 401(k) plans. Perhaps you don’t think a 1.5% management fee sounds high, but it can have a big impact on your retirement savings over the course of your career.

For perspective, some mutual funds and index funds have management fees of 0.05% or lower; a few even have no management fees at all. Although some mutual funds promise high returns, those are never guaranteed. Therefore, with all else being equal, the lower the management fees, the better.

FAQs

Bottom line

Although many employees prefer pension plans, 401(k) plans have their advantages. Pension plans tend to offer more consistent, predictable payouts (and do so for life), but 401(k) plans tend to give employees more control over their investments.

For those who prefer to construct their own portfolio, a 401(k) could be preferable. Just remember that managing your own investments subjects you to market risk, which isn’t a part of the picture with pension plans.

Either retirement savings plan can work, however, and it’s often a good idea to develop a retirement fund on your own that isn’t tied into your employment. For help in deciding how to invest money for retirement, consider talking with a financial advisor.