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Comparing 401(k) Plans and Pensions

Darrach Bourke

· Pensions
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Both 401(k) and pensions are employee benefits aimed at supporting an employee during their retirement years. A pension is a defined benefit plan, while a 401(k) is a defined contribution plan. This means that, with a pension, the benefit is specified. It could be a dollar amount such as $1,000 a month during retirement. Alternatively, the exact pension amount could be calculated considering a person’s salary and the number of working years. Either way, with a pension, an employee knows how much to expect during retirement.

The benefit accruing from a 401(k) is dependent on the contributions of the employee to the plan, contributions that may be matched by the employer. Another factor that impacts retirement income from 401(k) benefits is the employee's investment choices with their 401(k) plan. The exact amount of the benefit is unknown until the funds become available upon retirement.

Before 401(k) plans arrived on the scene, pensions used to be the retirement plan used for employees. An employee working a specified number of years becomes eligible for a pension. Once this happens, the employer sets aside a set amount for the employee's retirement. The pension is a monthly payment to the employee starting upon retirement and continues for the rest of the employee’s life. When the employee passes away, the pension may be passed on to the spouse or a beneficiary. The employee is not concerned about investments. They get the same amount month after month.

With a 401(k), an employee sets aside a part of their salary for retirement with a set limit for contributions. Contributions to a 401(k) are tax-deferred until withdrawal. Another type of 401(k) called a Roth 401(k) is taxed upon contribution but is tax-exempt during withdrawal. Under a 401(k), employers may match the contributions of an employee. With a 401(k), employees are required to select their preferred investment vehicles.

Because of the guaranteed monthly income, a pension has more stability than a 401(k). A person with a pension knows how much they will be getting upon retirement and can budget accordingly. A person with a 401(k) is dependent on the performance of the assets the 401(k) funds have been invested in and the contribution amount. That said, there are ways to go about saving for retirement that use both 401(k) and other retirement saving vehicles so that the retirement income stability of a pension is approximated.

The first piece of advice is to start investing in a 401(k) as early as possible to take advantage of the income growth benefits of compound interest. Another good strategy, if the 401(k) limit has been reached, is to open an Individual Retirement Account (IRA).

The following strategy involves buying an annuity. Much like a pension, an annuity is a means of getting regular monthly payments upon retirement. It is an insurance contract that may be purchased from an insurance or financial services company. Some annuities are known as fixed annuities. These annuities are most like pensions because they generate a guaranteed fixed monthly income. Other annuities are variable annuities. These are like 401(k)s in that the monthly payment is dependent on market performance.