401(k) vs. Pension Plan: What's the Difference?

If you’re employed with a company and saving for retirement, you might have either a 401(k) or a pension plan. Both are retirement savings plans through which you can benefit from employer contributions that help you set up a solid financial future and accelerate your savings.

But what’s the difference between these two types of retirement accounts?

To begin with, a 401(k) relies on your own investments plus a potential employer matching percentage. In contrast, a pension is contingent on the number of years you’ve worked for a company and employer contributions.

There are many other differences between these retirement plans as well. In this article, we’ll explore the differences between 401(k)s and pension plans, as well as the benefits of each.

401(k) Plan

Historically, pension plans were a common retirement savings account employers offered. Today, 401(k) plans have surpassed pensions in popularity. If you work for a private company and they provide you with retirement benefits, there’s a good chance you have a 401(k).

What’s a 401(k), and how does it work? It’s a type of retirement plan funded mostly through your own contributions as an employee, which are made as regular payments, pre-tax or post-tax from your paycheck. If you elect a tax-deferred 401(k), the IRS doesn’t consider your 401(k) contributions as part of your taxable income for the year.

Your employee contributions are deposited into your 401(k) each month or pay period. They are invested in mutual funds, ETFs, and other investments you choose from a set of options the plan offers. In this setup, you aren’t guaranteed to earn a given amount from your investments, as you take on all investment risks individually.

Your employer may offer additional contributions to this savings account, called employer contributions. Often, this is in the form of a matching program, where your employer pledges to contribute a percentage of your income based on the set amount you commit to saving. A matching program is attractive to employees because it can seem like free money, helping to boost your overall compensation and savings rate.

Typically, there are standard investment options that you can choose from when you invest your 401(k) contributions, including the following securities:

• Mutual funds: These are instruments that pool money from a group of investors and invest it in securities like stocks and bonds, as well as other assets to help individuals benefit from upsides across the market.
• Company stock: Some companies offer company stock as part of their 401(k) plan offering. Some even may offer it at a discount to market value.

• Annuities: This type of investment can provide lifetime income in retirement, which can help provide security to investors. Investors must make regular contributions or premiums to benefit from this type of asset.

Because 401(k) holders bear the risk of their investment choices, conducting thorough research, reviewing IRS guidelines, and speaking to a financial professional when assembling your portfolio is essential.

Top Benefits of a 401(k) Plan

401(k) plans provide many benefits for employees. Some of the key features include:

• Employer Matching: If your employer offers to match your contributions to your retirement plan, you can significantly accelerate your retirement savings by making the most of “free money.” Remember that this varies by employer; some may not offer a matching program.
• Protected by federal law: 401(k) accounts are protected by ERISA laws — the Employee Retirement Income Security Act — so creditors cannot seize them in the event of bankruptcy.
• High contribution limits: 401(k) accounts have higher contribution limits than other retirement savings options, like IRAs. The IRS sets this amount, and in 2023, the limit for employees under 50 is $22,500. Those who are over age 50 can make catch-up contributions of $7,500 for a total contribution limit of $30,000. Additionally, employees benefit from vesting, which allows them to keep the total employer contribution amount after leaving the company.
• Potential for loans: There are options to withdraw or borrow from your 401(k) in an emergency before retirement age.
• Mobility: If you change jobs, you can bring your 401(k) with you.
• Taxes: Traditional 401(k)s offer tax-deferred contributions, which means you make investments with your income pre-tax. This will reduce your taxable income level in the present, and therefore lower your tax bill in the current year — although you’ll need to pay taxes on future withdrawals.
  • For Roth 401(k)s, you can make after-tax contributions in the current year, but then you can withdraw the funds tax-free in retirement.

Pension Plans

While pension funds are also retirement savings plans, they are structured differently than 401(k) plans. With pension benefits, the employee doesn’t choose where to invest the money. That decision, and the associated risks, are taken on by the employer, who makes contributions to a fund they manage alongside a plan administrator. Sometimes, employees can also make mandatory or voluntary contributions to their pension plan.

Because the employer is in charge of the investments and risks, the employee can incur some adverse effects. For example, your benefits may decline if the portfolio performs poorly or the company goes out of business. To mitigate this scenario, most pensions are insured by the Pension Benefit Guaranty Corporation (PBGC), making pensions less risky than 401(k)s in most situations.

The critical difference is that pension benefits are not based on employee contributions. Instead, employers contribute to the fund and then promise to pay you a designated amount of money when you reach retirement age.

This retirement income doesn’t have a time limit; it’s life-long. The amount will be paid monthly and is usually based on a percentage of your average salary during your time at the company—for example, 2% of your average salary from your last five years of work, multiplied by your total years of service.

The fund has to be vested, giving employees access to the total amount after a certain period or set number of years.

Top Benefits of a Pension Plan

Some of the top benefits of a pension plan include:

• Compound interest on earliest investments: Investments made early can grow significantly over time and increase your retirement income.
• Pension plan payout upon retirement: Employees are incentivized to work for as long as possible at the company because the number of years of service determines their retirement income, with more years equating to a higher income. This is unusual in the private sector, which typically depends on 401(k)s.

• Guaranteed income via annuity at retirement: You’ll receive a monthly payment for your retirement years, no matter how long you live.
• Easier financial planning: Because of that monthly annuity payment, you can more easily plan your life because there is a monthly lump sum you can predict.

Pension vs. 401(k)

Both types of retirement plans have unique benefits and may be more suited for individuals in different circumstances; neither is objectively better. That being said, you may not even have a choice over your type as the employer determines it.

Here is a breakdown of how the two account types stack up according to some essential factors:

• Risk: A pension plan can be seen as less risky for the employee since, with a 401(k), the employee bears the risk of market investments which can determine how much money you have in your retirement fund.
• Earnings: On the other hand, because of the capacity to choose your own investments with a 401(k), you may have access to more growth and higher returns than a traditional pension.
• Income consistency: Since pensions guarantee income for your entire lifetime in retirement, you can depend on regular earnings, whereas your 401(k) is a pool of funds that can be depleted.
• Vesting: A 401(k) might be able to begin earning money right away, whereas, with a pension, it can take a number of years before the employee is fully vested.
• Mobility: If you plan to stay in one job for life, a pension could be a great retirement savings plan. But 401(k)s can be moved more efficiently and rolled over into new plans or Individual Retirement Accounts (IRAs) when you move jobs, making it easier to bring the investments with you.

Can You Have Both a Pension and 401(k)?

Yes, it is possible to have both a pension fund (sometimes also called a defined benefit plan) and a 401(k)(sometimes called a defined contribution plan). Typically, one employer won’t offer both.

Technically, distributions from Social Security are a type of pension plan payment, although that is not usually what people mean when they speak about having a pension. But having either a 401(k), a pension, or both can help you supplement your Social Security income during your retirement years.

If you have both accounts, you can keep contributing to your 401(k) while you take distributions from your pension during retirement.

The Bottom Line

A 401(k) is a retirement plan that allows employees to make contributions pre-tax (or in certain cases, post-tax) which the employer can match if they offer that option. Employees then choose how to invest the money and can bring the account with them when they change jobs.

A pension will guarantee monthly income for your life in retirement, but the employer controls the investments, and the plan is linked directly to that job — making it harder to move if you change companies.

Both account types have benefits and risks, and neither is objectively better.

Whichever retirement plan you have, you must keep track of your account when you change jobs. If you have a 401(k) or a pension plan from a previous employer, consider working with a qualified financial advisor to see if it’s worth rolling over your previous plans into your existing plan or another account.

Capitalize is a free rollover service here to help you streamline your finances without stress. We have a solid track record of helping thousands of savers like you make their retirement investing experience as simple as possible.

Reach out to us today to learn how we can help you get your personal finances in order.