What is a Pension Plan?
A pension plan (sometimes called a defined benefit plan) is a type of retirement plan that promises a predetermined monthly benefit payment to employees when they retire. The amount is based on factors such as age, salary, and total years of service, and these plans are primarily funded by employers. By design, pension plans provide retirees with a reliable income stream which in turn provides financial security in their later years.
It's worth mentioning that pension plans are not as common in the United States as they once were. They're still used by some professions, including government jobs, some teachers, some public service workers, and some unionized jobs.
How Pension Plans Work
Most pension plans operate as defined benefit plans where the benefit calculation multiplies the number of years worked by a percentage of the employee's salary which then produces a stable income amount for retirement. There are vesting requirements that dictate how many years an employee must work before they are entitled to receive employee benefits, and in terms of payout, they can usually choose to receive either a monthly annuity for life or opt for a lump sum distribution that they can then manage independently.
The Pension Benefit Guaranty Corporation (PBGC) plays a vital role in the protection of most private-sector pension plans as they insure them so that retirees receive the retirement benefits they were promised—even if their former employer winds up facing financial difficulties later on.
What is a 401(k) Plan?
A 401(k) is a type of defined contribution plan that allows employees to save for retirement by contributing a portion of their salary on a pre-tax basis. These plans are primarily funded by employee contributions, though they often include employer matching contributions. An employer matched contribution is where employers match contributions up to a certain percentage that are made by an employee of their organization in a given year.
All employee and employer contributions to 401(k)s are made with pre-tax dollars - meaning that they are tax-deferred until you begin to draw from them in retirement.
How 401(k) Plans Work
In a 401(k), employees contribute a portion of their salary to their retirement savings, adhering to annual contribution limits set by the Internal Revenue Service (IRS).
In 2024, the limit is $23,000. However, if you are 50 and over, you can contribute a catch-up amount of an additional $7,500 in order to accelerate your savings because you are more quickly approaching retirement.
The average 401(k) is managed by a fund manager or financial services advisory group, but employees should have several investment options to choose from, including mutual funds, stocks, bonds, and ETFs.
You can start withdrawing from your 401(k) investment account once you reach 59½ years of age, but touching the money before then would likely result in a 10% early withdrawal penalty in addition to the regular income tax you'll pay on the amount withdrawn.
Comparing Pension Plans and 401(k) Plans
Funding Sources
Pension
Pension plans are typically employer-funded, where the responsibility for contributing to the pension fund falls entirely on the employer. This structure means that employees can receive a guaranteed monthly benefit once they retire, regardless of how the market performs.
401(k)
401(k) plans are employee-funded with employers offering to match contributions as an incentive, but the responsibility is on the employee to manage their investments and ensure that their contributions will be adequate for retirement.
Control Over Investments
Pension
In a pension plan, employees usually have little to no control over how their own investments are managed as their employer designates a plan administrator to be responsible for the investment decisions. Because of this setup, employees can receive a predetermined benefit amount when they retire as the employer has taken the risk.
401(k)
In a 401(k) plan, employees have significant control over their investments and can choose from a range of asset classes based on their risk tolerance and financial goals. This autonomy means employees can tailor their investment strategy to align with these goals, but it also means they're responsible for making informed decisions about savings and potential market risks.
Payout Structure
Pension
Traditional pension plans offer retirees guaranteed monthly payments for life, which provides a stable and predictable income stream they can count on during retirement. Because the amount is based on salary and years of service, retirees can plan their finances accordingly, knowing how much they can expect to receive.
401(k)
401(k) plan payouts depend on account balance and investment performance, meaning that the amount available for retirement can fluctuate based on changing market conditions and personal investment decisions. This adds an element of uncertainty as far as future income is concerned.
Advantages and Disadvantages
Pension Plans
Advantages
One of the primary benefits of a pension plan is the predictable income it offers, which can provide security and peace of mind. This structure effectively covers longevity risk and mitigates concerns about outliving your savings.
Disadvantages
Pension plans lack portability, so if an employee changes jobs, they could lose their pension benefits or even face penalties for early withdrawal. They also have less control over investment decisions, which remain with the employer or plan administrator.
401(k) Plans
Advantages
A key benefit of 401(k) plans is the flexibility they offer in terms of investments, giving employees lots of choices about how funds are put to work in order to grow. There’s also the potential for employer match contributions, which provide an excellent way to boost savings without paying more out of pocket. Lastly, they're also portable, so employees can take their accumulated funds with them when they change jobs and have the option to rollover into an IRA (such as a PensionBee IRA).
Disadvantages
401(k) plans expose employees to higher market risk as the value of their investments can fluctuate based on market performance. They also don't provide a guaranteed income stream, so it's truly up to the employee to be diligent about managing their savings effectively to make sure they have enough for their future needs.
The Role of IRAs in Retirement Planning
Individual Retirement Accounts (IRAs) serve as a valuable additional retirement savings vehicle that enables you to further enhance your savings plan beyond just your employer-sponsored plan. Traditional IRAs allow you to make tax-deductible contributions so you don't pay until you withdraw funds as taxable income in retirement, while Roth IRAs are funded with after-tax contributions, meaning you can enjoy tax-free withdrawals once you leave the workforce.
IRAs provide a lot of flexibility, enabling you to manage your tax liability based on either your current or anticipated future income level. They can complement 401(k)s by serving as an additional layer of savings, offering tax advantages, and giving you the ability to diversify your retirement portfolio for decreased risk and potential gains. Consider a PensionBee IRA where you can choose a plan that is right for you.
