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Retirement Planning: Pension vs. 401(k)

Learn how a pension stacks up to a 401(k) and how they can work together to fuel your retirement.

Justin Cupler

Contributing Writer at Tally

August 18, 2021

Retirement requires a healthy nest egg to ensure you can make it through your golden years without running out of money. For many, this means investing in a 401(k), individual retirement account (IRA), the stock market and other retirement accounts.

A pension is a different animal altogether as it offers a fixed income in retirement without you needing to invest a single dollar.

How does a pension stack up to a 401(k)? We’ll investigate a pension vs. a 401(k) to expose their key differences as well as their pros and cons.

What is a pension plan?

A pension is a defined benefit plan, which means it pays a specific monthly benefit in retirement. This payout can come in two forms. It can be:

  • A set dollar amount, such as $2,500 per month

  • Based on other factors, like years of service or highest salary ( ex:1.5% of your last five years’ average salary for every year worked)

Consider you worked for a company for 20 years and averaged $80,000 per year each of your last five years. If the company offered 1.5% of your salary as a pension for every year worked, your pension would be 30% of your salary (20 x 1.5 = 30). This would come out to $24,000 per year (80,000 x 30% = 24,000) or $2,000 per month.

In a pension plan, the employer makes periodic investments into a pool of funds that pays workers their monthly benefit. The employer must make a set contribution to the fund and control the investments that help it grow. There is no expense passed to the employee.

Then, the company pays its retired workers from this pool every month. If the pool shrinks to a point where it can’t make full payments to employees, the employer covers the difference.

How common are pension plans?

At the peak of their popularity in the 1980s, 38% of private employees had pension plans to help them in retirement. Today, pensions are a relative rarity in the private sector, with about 15% of employees receiving one.

Pension plans remain popular in the public sector, with 86% of state and local government workers receiving them. This includes occupations like law enforcement, mail carriers, DMV workers, politicians and more.

What are the pros of a pension plan?

There are plenty of benefits to a pension plan.

It gives you a baseline retirement income

You know you’ll make at least a certain amount of income in your retirement with a pension. This allows you to build a firm baseline income for your retirement plan.

You don’t need investment knowledge

The employer or a financial intermediary handles all the investing of the funds the employer contributes. This means you are hands-off in the investment part. You simply reap the rewards of the pension.

Pension funds have tax benefits

The pooled pension funds typically grow with a capital gains tax exemption, and their growth is tax-deferred or exempt from taxes altogether. This means there’s less of a chance the pension fund runs dry during your retirement.

In retirement, IRS and local tax offices will tax the payouts as normal income.

Most pensions are insured

Though they can run out of funds, many pension payments are insured to a legally defined limit by the Pension Benefit Guaranty Corporation (PBGC). As of August 2021, the PBGC will cover up to $1,508.52 per month if you lose your pension at 45 years old to $18,343 per month if you lose your pension at 75 years old on a straight life annuity.

On a joint annuity or a 50% survivor annuity, the insurance covers $1,354.64 at 45 years old to $16,509.27 at 75 years old.

If your pension is insured, funds will keep flowing; however, there is a chance the maximum yearly payout is less than you’d earn normally.

Pensions offer payout options

Pensions have various payout options in retirement, allowing retirees to choose the process that best fits their circumstances:

  • Annual payout. If you take an annual payout, you agree to a fixed payment every year until you die. After death, the payments stop unless you opt for a joint or survivor annuity. The annual payout is generally 10% lower in a joint or survivor annuity, but the annual payouts continue after death.

  • Lump-sum. In this situation, you agree to forgo the yearly annuity payments and take one large payment at retirement. This gives you the freedom to put the lump sum in the investment you prefer to help fund your retirement, like the stock market or annuities.

What are the cons of a pension?

While finding a job with a pension is generally a good thing, there are some cons to keep in mind.

A pension may require vesting

Your employer may automatically enroll you in the pension plan within the first year of employment, but you may not be eligible for retirement benefits for a number of years. An employer can spread out your vesting in the pension — eligibility to receive benefits — over up to seven years.

For example, you may only be eligible for 10% of the benefits upon enrollment and an additional 10% each year through your sixth year of employment. Then, in your seventh year, you would reach 100% eligibility.

Alternatively, you may get 100% eligibility immediately, but you may lose a portion of the benefits if you leave the company before retirement.

Companies can freeze pensions

When you get into a company with a pension plan, you’re immediately ensured you’ll receive a pension of some sort — thanks to PBGC insurance. However, companies can freeze pensions or cap the benefit amount despite working for the company longer or earning a higher salary.

Your payout is set

With a pension, you have no control over its investment strategy, and your payout is set. So, if you consider yourself an investment expert, you can’t use your investing skills to boost your portfolio and increase your retirement income.

Pensions can disappear

If a company goes bankrupt or your pension loses all its funds, it may not offer payouts or could significantly reduce them. Fortunately, PBGC insurance guarantees some sort of payout, but it may be just a fraction of what your pension was supposed to be.


Does a pension impact your retirement planning?

Yes, having a pension can greatly change your retirement planning, as it’s virtually guaranteed income in retirement.

You can determine its effect on your planning by estimating the income from your pension in retirement and seeing how this changes your monthly financial needs.

First, determine your retirement age and estimate your pension’s annual payout. You can find these estimates in your pension documents.

Next, assume your company will go bankrupt, and you’ll have to rely on PBGC insurance to cover your annual payout. Using the PBGC guaranteed monthly payment table, determine if the maximum PBGC payment would cover your full estimated pension payment at your planned retirement age or only a portion of it.

If the PBGC covers only part of it, use the PBGC maximum payment as your estimated pension payment. If the full PBGC payment is high enough to cover the entire estimated pension payment, keep your original pension payment estimate.

Finally, deduct the estimated pension income from your income needs in retirement, and you’ll find you need less from other sources, such as your 401(k) or Social Security. You could trim your retirement savings or continue at the same pace and have more income in retirement.

What is a 401(k)?

A 401(k) is a retirement savings account that’s similar to a pension. However, it’s a defined contribution plan instead of a defined benefit plan. The employer sponsors the plan, but the employee makes periodic contributions — typically on a per-paycheck basis. Plus, some employers will match a percentage of an employee’s contributions.

For example, an employer may match 50% of an employee’s contributions up to 6% of their salary. So, if an employee earns $100,000 per year and contributes $6,000 per year, they would receive an extra $3,000 per year in employer contributions in their 401(k).

The employee contributions are tax-deductible, so they lower your post-tax income. Plus, 401(k) growth is tax-deferred until the employee starts making withdrawals.

Unlike a pension, the employee controls their monthly income by simply drawing more or less money, as needed. The rule of thumb is to withdraw 4% of your 401(k) balance per year to live on. Based on historical averages, this will give you the funds you need to live without depleting your principal balance. However, the 4% rule has come under scrutiny recently due to falling interest rates.

So, if you have a $1 million balance in your 401(k), the 4% rule says you can withdraw up to $40,000 per year to live on in retirement without depleting the base $1 million balance. You’re basically living off the interest.

It’s also different from a pension because the employee controls 401(k) investments — to an extent. The employee can choose from a range of investment options, including stock and bond mutual funds with varying levels of risk and potential return. The employee lacks full control because 401(k)s generally have limited mutual funds to pick from.

How common are 401(k)s?

These retirement accounts are far more common than pensions, as 56% of employers offer them. Of that 56%, the employer matching varies greatly. Nearly half (49%) offer no employer match and 41% match up to 6% of the employee’s salary. Only 10% of employers match 6% or more.

What are the pros of a 401(k)?

The 401(k) has become a go-to retirement vehicle as pensions become rarer. Fortunately, 401(k) retirement accounts have plenty of pros working in their favor.

You’re in control

With a 401(k), you’re in the driver’s seat, as you control how much to contribute and all the investment decisions. This allows you to fine-tune your retirement savings to meet your goals instead of trying to stuff your goals into that pension-shaped box.

You can withdraw what you need

While you generally want to stretch your 401(k) by withdrawing only what you earn in interest or less, there are times when an emergency crops up. When these emergencies strike, you can dip a little deeper into your 401(k) savings to cover it instead of relying on your fixed pension payment.

You can take it with you

If you leave a company, you can roll your vested 401(k) balance into your new company’s 401(k) offering. Due to vesting rules, you may not be eligible to roll over all your employer contributions, though.

The employer match is like “free money”

The employer match is free money. Suppose your employer matches 100% of your contributions up to a certain percentage of your salary, and you maximize those contributions. In that case, it’s the same as getting a 100% return on your investment every single year. This is on top of the normal interest you’ll earn from your contributions and the employer match.

Your 401(k) comes with tax benefits

A 401(k) account has dual tax benefits. First, you contribute to it with pre-tax dollars from your paycheck. This reduces your income now, so you pay less in income taxes today.

Your 401(k)’s growth is also tax-deferred, meaning you won’t pay income taxes on the interest your investments earn until you retire and begin receiving periodic disbursements from the account. The IRS treats these withdrawals as normal income and taxes them as such.

Since your disbursements are likely significantly lower than the salary you left behind, you may land in a lower income tax bracket than when you were contributing to the 401(k). This means lower taxes once you start taking disbursements.

You can take loans against your 401(k) if needed

Sometimes an emergency strikes, and you need money. Instead of turning to credit cards or cash advances, you can borrow from yourself — more specifically, your 401(k).

You can usually request a 401(k) loan for up to $50,000 or 50% of your vested balance, whichever is lower. Then, you repay the loan under the terms you agree to. Any interest attached to the loan isn’t paid to the bank. Instead, that interest goes directly into your 401(k) — you’re paying yourself interest.

A 401(k) loan also doesn’t require a credit check and will have zero impact on your credit score. The biggest downside is if you leave the company sponsoring your 401(k) before repaying the 401(k) loan, you may get hit with a taxable disbursement plus the 10% federal tax penalty for withdrawing before you turn 59.5 years old.

The other downside is you may miss out on 401(k) growth if the stock market surges after taking money out of your account for the loan.

What are the cons of a 401(k)?

There’s a lot to love about 401(k) accounts, but they aren’t perfect. Here are a few cons to a 401(k).

They have contribution limits

The IRS limits how much you can deposit into a 401(k) every year. In 2021, you can contribute up to [externalLink copy="$19,500 to your 401(k) per year"]. If you’re over 50 years old, you can add another $6,500 in catch-up contributions, bringing the total contribution limit to $27,000.

You can lose money

Your 401(k)’s value is based on the stocks and bonds you invest in, meaning you can lose money if the market is down. Fortunately, 401(k) investments are generally diversified funds instead of individual stocks, which mitigates the risk of losing everything.

They have strict disbursement rules

The government puts strict rules on when you can withdraw cash from your 401(k) without penalties, and it also tells you when you must start making withdrawals.

Aside from a few exceptions, you can’t start making withdrawals from your 401(k) until you’re [externalLink copy="59.5 years old"]. If you make withdrawals before then, they are subject to a 10% penalty.

One exception to this rule is you can make penalty-free withdrawals if you leave your job — fired, quit or retired — in the calendar year you turn 55 years old or later. For safety workers — firefighters, air traffic controllers, police and others — the age for penalty-free early withdrawals is 50.

On the other side, you must start taking disbursements by April 1 of the year following your 72nd birthday.

Should you enroll in a 401(k) if you have a pension?

When it comes to retirement savings, diversification can be a great tool to mitigate risk. Stock, bonds, individual retirement accounts (IRAs), 401(k)s, Social Security and pensions can all play a role in your retirement. Being diverse ensures a downward trend in one retirement account doesn’t leave you broke in your golden years.

If you have the option to invest in a 401(k) in addition to a pension, consider talking to a financial advisor to see if the opportunity is the right fit for you.

Pension vs. 401(k): No competition, just diversification

There are some key differences between pensions and 401(k) accounts. The key differences are pensions don’t require employee investment and guarantee income after meeting specific requirements, whereas 401(k) accounts require employee contributions and aren’t guaranteed. Plus, an employee can roll an old 401(k) into a new one if they leave their job.

Though they have distinct differences, pensions and 401(k) accounts can work together to help you have a more secure retirement. Diversifying your portfolio by combining a 401(k) and a pension provides you a guaranteed base income from the pension but gives you the greater investment options of a 401(k).

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