When you’re ready to retire, you’ll want to have more than Social Security to pay the bills. Those benefits typically only provide enough money to replace about 40% of average earnings.
To live comfortably in retirement, you should have either a traditional pension plan or a defined contribution plan, like a 401(k) account. While both plans provide money in retirement, they are vastly different in how they are set up and administered.
To understand the basics of each account, including the benefits, disadvantages and differences between a pension plan vs. a 401(k), use this guide.
What Is a Pension Plan?
As a workplace benefit, pensions give workers a monthly payment in retirement so long as they have met certain eligibility criteria. Typically, companies will require that employees work a minimum number of years to receive a pension, and they must reach a certain age before getting a stream of retirement payments. The pension benefit is usually calculated with a formula that takes into account a person’s years of service and earnings.
Employers fund pensions entirely, and employees usually don’t have to make any contributions to gain this benefit. As a result, workers have limited control over how they receive their pension. Some companies give employees the choice of receiving their pension in a lump sum, but monthly payments are more common.
Plans may also offer a spouse survivorship option. If selected, workers will get a lower monthly payment but a spouse will be entitled to continue receiving benefits after the worker dies. It can be difficult, if not impossible, for a retiree to change this election, so workers should carefully consider their health and life expectancy as well as that of their spouse when deciding whether to opt into spouse survivorship.
“From an employee standpoint, we don’t see any downside (to pensions),” says Harry Dalessio, head of institutional retirement plan services at Prudential Retirement. However, they can be hard to come by nowadays. Only 14% of Fortune 500 companies offered pensions to new hires in 2019, according to a study from global advisory and solutions firm Willis Towers Watson. That compares to 59% of large companies offering pension plans in 1998.
The decline in pension availability is related to their high cost. A company promises that in exchange for years of service, it will financially support a worker throughout his or her entire retirement. However, that has become an expensive promise, especially now that the baby boomer generation has hit retirement age.
“You have this massive group of people moving through the system,” says Chad Parks, founder and CEO of Ubiquity Retirement + Savings, an online provider of 401(k) plans. “It’s like an albatross around the neck of companies.”
The problem is especially acute in public pensions. A 2019 report from The Pew Charitable Trusts found state pension systems had a $1.28 trillion funding gap in 2017.
While governments are grappling with how to pay for pensions for teachers and civil servants, private sector workers typically don’t have to worry about their pension being lost to underfunding. The Pension Benefit Guaranty Corporation, a government agency, insures the pensions of some 37 million private workers.
What Is a 401(k) Plan?
As companies have phased out pension plans, they have replaced them with 401(k) plans, which shift the responsibility of saving for retirement to workers. “Defined contribution plans were never built to be the primary retirement vehicle for workers,” Dalessio says. However, the reality has become that many workers will be relying on them heavily to pay for retirement.
In 2020, employees can contribute up to $19,500 to a 401(k) plan. Those age 50 and older are entitled to make $6,500 in catch-up contributions, for a total annual contribution of $26,000. “In theory, you would want to contribute the maximum amount,” says Tim Speiss, co-leader of financial firm EisnerAmper’s Personal Wealth Advisors Group.
Many employers make contributions to workers’ 401(k) accounts. However, employees may need to work a certain number of years to become vested and fully entitled to that money. What’s more, firms will often match a certain percentage of a worker’s contributions to the plan, though this may be subject to vesting requirements.
“Do not leave the free money on the table,” says Sandy Eichel, wealth management advisor with Northwestern Mutual in the Madison, Wisconsin, area. “I’m constantly surprised at how many people are not taking advantage of the match.”
There are two versions of 401(k) plans and each offers its own tax benefits. Traditional 401(k) plans offer a tax deduction at the time contributions are made. Money grows in the account tax-deferred and then is subject to regular income taxes when withdrawn in retirement; the money taken out of an account prior to age 59 1/2 may be subject to a 10% penalty. Once a retiree reaches age 72, he or she must begin making required minimum distributions or pay a penalty equal to 50% of the distribution amount.
Roth 401(k) plans, on the other hand, do not provide a deduction for contributions but can be withdrawn tax-free in retirement. Like traditional 401(k) accounts, there may be a 10% penalty on early withdrawals but that only applies to investment gains. Since the contributions have already been taxed, there is no penalty for withdrawing a portion of the principal early. Unlike traditional accounts, Roth 401(k) plans have no required minimum distributions in retirement.
“Taxes are probably going up in the future,” says Jeff Soltow, co-founder of Frontier Wealth Management in Spring, Texas. He notes that the national debt has been climbing steadily and, at some point, taxes will likely need to rise for the country to continue meeting its financial obligations. With that in mind, investing in a Roth 401(k) rather than a traditional account may be a smart decision.
Pension vs. 401(k): Which Is Best?
The major differences between pensions and 401(k) plans can be summed up as follows:
- Pensions are primarily funded by employers while 401(k) plans are primarily funded by employees.
- Pension investments are controlled by employers while 401(k) investments are controlled by employees.
- Pensions offer guaranteed income for life while 401(k) benefits can be depleted and depend on an individual’s investment and withdrawal decisions.
All this means there is a lot for workers to like about pension plans. “It’s basically a lifetime income for whoever the pension holder is,” Soltow says. Plus, if the market drops, workers don’t have to worry about their monthly payments declining.
However, with a 401(k), if investments fail to perform as expected, it has a direct impact on a retiree’s nest egg. Employees are also given control over which funds within a company’s plan to place their money and that too can come with risks. “It’s a flawed system in that we expect an average person to become a savings and investing expert,” Parks says.
For example, workers may be placing money in aggressive funds when they should be investing more conservatively or vice versa. To help workers make smart decisions, many 401(k) plan administrators offer educational tools or even access to financial advisors to help guide investment elections.
“Most people are not super confident in how they have their money allocated,” Eichel says. Even those who feel like they can do their own research may benefit from speaking to an advisor who can help align investments to life goals.
Another significant difference between pension and 401(k) plans is transparency. While 401(k) plans make it easy for workers to see where their money is invested and how it is performing, there is no such option with a pension plan. “There’s really not a lot of room for people to self-direct their investments (in a pension),” Speiss says.
When it comes to comparing a pension plan vs. a 401(k), pensions are often seen as the clear winner. However, the smart use of a 401(k) plan can provide benefits that make for a comfortable retirement. To make the most of your company-sponsored retirement plan, start saving early, maximize your employer’s match and watch your balance grow.
Original source: U.S.News