How is a 401(k) Different From a Pension?

401(k) Retirement Investing Guide for Your Nest Egg
••• With 401(k) accounts and plans replacing pensions as the primary source of retirement income in the United States, it is more important than ever you understand how your 401(k) account works and how you can benefit from it. Don Farrall, Photodisc, Getty Images

For better or worse, retirement savings accounts don't come "one-size-fits-all". One of the biggest trends in the retirement plan industry over the past few decades has been the shift from the traditional defined benefit pension plans to defined contribution plans like 401(k) plans. When it comes to the complicated process of creating a retirement savings plan, it is important to understand how a 401(k) differs from a traditional pension plan.

There are two main types of company sponsored retirement plans with significant differences for retirement savers. These potential sources of retirement income––defined benefit plans and defined contribution plans––are both retirement accounts available through employers. But that is where the differences end.

Basic Characteristics of a Pension Plan 

A defined-benefit plan such as a pension plan is an employer sponsored plan where employee benefits are calculated using a formula that looks at factors such as length of employment and salary history. With pension plans your employer contributes money to the plan while you are working. Pension plans provide guaranteed income and all of the investment risk is placed on the plan sponsor. While traditional pension plans have consistently declined in popularity over recent years they are the most common example of a defined-benefit plan.

The formula a pension uses is generally based on a combination of the following factors:

  • Your years of service with the company offering the pension
  • Your age
  • Your compensation

Most pension benefits are taxable when you begin receiving income. If you work for an employer that offers a pension it is important to recognize they can choose to terminate the plan. In the case that your pension plan is terminated your accrued benefit usually becomes frozen.

In this scenario you will receive benefits earned up to that point, but you will no longer accumulate any additional service credits.

In certain situations pension plans have been mismanaged in the past and unable to pay out all of the promised benefits for participants. If the pension plan was covered by the Pension Benefit Guaranty Corporation (PBGC) some benefits are protected for pension plan participants

Basic Characteristics of 401(k) Plans 

Defined-contribution plans depend on participant contributions and the 401(k) is the most familiar example of these types of retirement saving vehicles. 401(k) plans place the burden of investment risk on individual employees.

A 401(k) or similar plan might be the single most effective way to fund your dream retirement if you are like the majority of people without access to a pension plan.

  • In 2018, you can contribute up to $18,500 (plus an additional $6,000 "catch-up" contribution if you are age 50 or older). If your contributions are made with pre-tax dollars, you could cut your final tax bill for the year by hundreds or thousands of dollars. 

  • If your employer matches contributions, the decision to participate is an easy one. Consider matching dollars a bonus you get every pay period. Try to contribute at least as much to your employer-sponsored retirement plan as you need to in order to get the maximum employer match.
  • Your money continues to grow sheltered from taxes until you withdraw funds. Distributions from a traditional pre-tax 401(k) account will be taxed at your income tax rate. 
  • Roth 401(k)s allow you to contribute after-tax dollars that can grow to be tax-free after age 59 ½ as long as you’ve had the account for at least 5 years. Choosing whether it makes sense for you to receive the tax savings now or later is a big part of the pre-tax vs. Roth 401(k) decision.
  • You have several investment options to choose from. One popular trend among retirement plans is to provide one-stop-shop approaches to diversifying investments in a 401(k) plan through target-date funds. Many retirement plan sponsors also offer professional investment management and guidance.

What If You Don't Have a Pension Plan?

The advantage of a pension plan is it provides guaranteed income.

Fewer companies offer pension plans compared to previous generations. This means the burden of saving for retirement falls on you as an individual. As a result you must figure out how to save enough to create your own pension-like income in retirement.

Are you saving enough to meet your retirement goals? 

The best way to find out is to run a basic retirement calculation at least once per year. A variety of different retirement calculators exist these days to help you run a simple retirement calculation to see if you are on the right track.