At some point in your adult life, you’ll start thinking about how you’ll be able to pay for your living expenses once you retire. But have you ever really given some thought to this question? Do you have enough money to live off when you retire? Should you opt for a pension or a 401(k)?
There are quite a number of things to consider before an employee selects which retirement plan to fund. Before deciding how to save their hard-earned income, it’s important for employees to know the answer to the question: What’s the difference between a pension and a 401(k) plan?
Retirement Planning Services
A pension plan is a retirement fund sponsored and paid for by the employer. It’s also sometimes referred to as a defined-benefit plan. The computation of how much pension an employee will get upon retirement is based on a formula that includes factors such as salary, age, and the number of years an employee has worked in the company.
A 401(k) plan is a retirement planning service made available as an option to employees of a company if they plan on saving for their retirement. But this option should be offered by the employer. There are some employers who match a portion of their employees’ 401(k) contributions. The employer sets aside funds for 401(k) by holding back part of an employee’s salary.
Features And Differences
Both a pension plan and a 401(k) plan are kinds of retirement plans. In a retirement pension fund, the pension plan is funded by the employer, while a 401(k) is funded by the employee. Those familiar with the technical financial terms would say that a pension plan is a defined-benefit plan while a 401(k) plan is a defined-contribution plan.
The Churchill Management Group discussed some of these distinctions. There are differences between the two in terms of:
- who makes contributions to the fund
- who has control over the retirement funds and what to do with them
- how the retirement funds will be managed before the employees retire
- how the fund will be paid out when the employee retires
- whether the employee is assured of receiving something regardless of how the funds invested perform
Certainty Vs. Flexibility
Another difference between a pension and a 401(k) is that a pension plan provides a bit of a fixed periodic pay-out while a 401(k) allows you to take some risk and make some more money. The pension provides more certainty because the employer contributes to the funds, it’s managed by an investment professional, and it guarantees to pay a fixed monthly income when the employee retires.
On the other hand, a 401(k) allows flexibility because the employee sets the schedule and amounts of contributions, has a say on where the funds will be invested, and allows room for high investment growth potential.
Control Over Investments
It’s not very enticing to withdraw funds from your 401(k) plan should you have the need for money because you will incur a penalty. The intention of the plan is to encourage employees to save for retirement. Any withdrawals (those made before the age of 59 and six months) will incur heavy tax penalties.
In pension plans, employees don’t have control of how the pension fund will be invested. Employees don’t assume the investment risk. What happens is that the contributions by the employer, the employee, or both are pooled into a common fund and set up into an investment portfolio. This portfolio would then be managed by an investment professional.
Guaranteed Income Vs. Growth Of Investments
The good thing about a pension plan that makes it attractive to many employees is that the employer, thru the pension plan, promises to provide a monthly income to retired employees for the rest of their lives. The monthly pay-out is based on the amounts contributed and the number of years the employee worked for the employer.
The promise of a guaranteed income in retirement comes with a caveat, though: the fate of the pension plan goes hand in hand with the fate of the company. If the company goes bankrupt or the portfolio performs poorly, then the benefits promised may be reduced if not altogether defaulted. Pension benefits might also be affected when either the company or the fund or both are beset by financial woes.
Risk And Growth Appetite
Since employers are the ones paying regular premiums to the pension plan, employee pensions are protected because most private pension plans are insured by the Pension Benefit Guaranty Corporation. Some financial planners would say that pension plans pose significantly fewer market risks to individual employees compared to availing of a 401(k) plan.
At the end of the day, pension plans are more suitable for those who would like to have some guarantee of receiving something every month when they retire. However, for younger employees who usually have more appetite for growth, can afford to take risks, and still have plans of moving to another career path, then a 401(k) plan affords more flexible features.