Pension vs 401k
Pensions and 401ks are two retirement plans that often get confused with one another. People say they have a “pension” when they really have a 401k, while others claim they have a 401k – just like everyone else they know – when in fact, they have a pension. Both are, in fact, retirement plans, and there are benefits to both 401k and pension plans. However, they are substantially different in the path they follow to a similar outcome. This article compares pensions vs 401ks as retirement plans and offers advice on how to use each to accomplish your retirement goals.
What is a 401k?
A 401k plan is a tax-advantaged retirement plan which is funded primarily through employee payroll contributions. Many of these plans allow the employer to also contribute on behalf of the employee, but the majority of the money comes from employee contributions. These plans are considered “defined contribution” plans.
401k Matching and Contributions
The contributions from the employer typically come from a 401k matching contribution and/or a profit-sharing contribution. The matching contribution is an amount established by a formula your employer will disclose to you at the beginning of each year. It is stated as a percentage of your contribution.
Two of the most common 401k matching formulas are:
A) 100% match of your contribution up to 4%, or
B) 100% match of your contribution up to 3% plus 50% of your match on the next 2%.
That can be confusing, so let’s look at some examples.
100% Match Formula
If you contribute 2% of your paycheck, the employer will contribute 2% to your account; if you contribute 3%, the employer contributes 3%; and if you contribute 4%, the employer contributes 4%. If you contribute more than 4% of your paycheck, the employer only contributes 4%. In this example, the employer’s match is limited to 4%.
100%/50% Match Formula
Similar to the first formula, but there are two rungs. If you contribute 3% of your paycheck, the employer contributes 3% to your account; if you contribute 4%, the employer contributes 3.5% (that’s 100% of the first 3% you put in plus 50% of the next 1% you put in). Since you contributed 4%, that’s 1% more, and the employer owes half of it.
Let’s say you contribute 5%. That breaks down to 3% (for the full match) and 2% (for the 50% match). The employer’s total contribution will be 4% to your account (3% plus 1%, which is 50% of 2%).
If you contribute more than 5%, the employer’s match is frozen at 4%, just like the first formula.
You do not need to limit your contributions to the employer contribution match. In fact, it would be wise for you to contribute as much as you can afford to, given your other goals and your personal cashflow. The only restriction is set by the government and is adjusted each year. Currently, the maximum amount you (the employee) can contribute is $19,500. However, if you are 50 years or older, there is a “catch up” contribution allowed, which is limited to another $6,500 per year.
401k Tax Deductions
One extra benefit of a 401k is that your contributions are tax-deductible, and the employer’s contribution is not taxed. When you contribute money into your 401k, your employer withholds your contribution from your paycheck before the money can be subject to income tax. Once the money is contributed into your 401k (either by you and/or by your employer), it can be invested in various investment options – usually mutual funds – which have been pre-selected by the employer. Some plans offer as many as 50 investment options, others are more bare-bones, offering 3 to 5 mutual funds, and the average is 8 to 12. The money invested in your 401k account can grow tax-free while it is in the 401k.
You get to make the investment decision. Therefore, you accept the investment risk; depending on how aggressive or conservative you are, you will have the opportunity to grow the balance substantially over the long-term or grow at a more modest and consistent pace.
Bottom line, whatever investment growth occurs in the 401k is tax-free. This is a significant benefit because it allows your money and your employer’s contributions to grow faster than they would if taxes were deducted each year.
401k Withdrawals
Finally, when you retire, and you’re ready to use that nest egg to enjoy your retirement years, you can withdraw whatever you need each year from the retirement account. Now, this is a complicated issue because the IRS has established some rules. You cannot withdraw too early (although there are hardship exemptions), and you must begin to withdraw a certain amount each year after you reach 72, but within those limits, you can withdraw whatever you want during retirement.
The amount that you withdraw is considered taxable income. Remember, at this point, you will have contributed money into your 401k, receiving a tax deduction for the contribution. You will have also grown your 401k balance without interest, dividends, or capital gains being taxed. It’s only fair that the IRS will recognize the withdrawal as income when you do withdraw. For many people, their tax rate in retirement will be significantly less than it was during their working years. If this applies to you, you have the added benefit of paying less on each dollar of income during retirement than you would have paid during your working years. This application has the effect of lowering the total taxes you pay over your entire life.
What is a Pension?
A pension is a retirement plan which the employer exclusively funds. These plans are considered “defined benefit” plans. Employees do not contribute anything to a pension plan. Instead, the employer is the sole contributor into a pension. This contribution is calculated using a formula that determines the yearly amount that the employer is required to pay the employee when they retire.
That’s a mouthful, so let’s explain what that means. If you have a pension plan at work, that plan states what benefit you’re supposed to receive when you retire. There are lots of formulas that can be used. Your employer can determine how much of a retirement benefit they want to provide. These benefits are usually expressed in terms of a monthly or annual benefit payment you’re supposed to receive when you work. Here are some very common formulas:
Flat Benefit Formula
Provides a flat benefit of $X for every year of service. As an example, let’s say your benefit is $400 for every year of service, and you’ve worked there 35 years. Your benefit would be $400 * 35 = $14,000/yr benefit
Unit Benefit Formula
Provides a benefit determined by both your length of service and your salary. As an example, let’s say your benefit is 2% for each year of service applied to the average wages over the last 5 years. If you worked for 35 years and your average income in the previous 5 years was $100,000, your benefit would be 2% * 35 * $100,000 = $70,000.
There are other formulas, but these are examples of the most common ones. In any event, your employer needs to explain the formula to you.
Each year, the pension plan hires an actuary to calculate how long every employee has until “normal” retirement and, based on the formula, their benefit. That’s the amount of money the pension plan must have at some point in the future to meet the benefit obligations. The actuary then calculates whether the existing investment assets will be sufficient based on projected rates of return. If they are sufficient, then the employer does not have to make a contribution to the pension that year. If the plan’s investment assets are not sufficient, then the employer must make a contribution to make up the difference as determined by law.
As you can see, you, the employee, have no control over what the benefit will be; you either stay with or leave that employer based on whether you like the benefit. You also have no control over the contribution made into your account. The amount of the contribution does not reduce your wages.
As you might imagine, you have no control over the investment decisions. Since the employer is on the hook for providing the benefit they’ve promised and for making sufficient contributions over the years to fund that benefit commitment, the employer is also responsible for making the investment decisions.
You might be tempted to think that you really don’t have any control in a pension plan and accordingly that there is some risk in trusting the employer alone for all these decisions. That would be spot on. If your employer did not make wise investment decisions and did not meet the minimum contribution requirements, there is a chance that your employer might not be able to make the benefit payments when you retire. Fortunately, there is a safety net in the form of the Pension Benefit Guaranty Corporation (PBGC), a U.S. Government Agency. If the PBGC covers your pension plan, this agency guarantees the basic benefits of your pension even if your employer is unable to do so.
Finally, as with the 401k plan, you can begin collecting the benefit which your employer’s plan defined when you retire. The benefit payments you receive will also be taxable, as they were with the 401k. When you’re ready to take your benefit, you will have different options for both a 401k or a pension. We’ll discuss those later, but here’s a quick recap of the key differences between a 401k and a pension.
Pension vs 401k Plans | What’s The Difference?
The key differences between a pension and a 401k are in the path each follows to take you to a similar goal – a successful retirement. Here’s a quick recap of pension vs 401k plans:
If you’d like more specific help in understanding your employer’s retirement plan or in choosing from among the various options provided by that plan, please feel free to schedule a complimentary consultation with us.
Pension vs 401k | Investment Decisions and Investment Risks
It bears repeating that one of the most important differences between pensions vs 401ks is in the area of investment decisions and investment risks. In a 401k, you are responsible for making the investment decisions. This is one of the bigger benefits to 401k plans. You get to make your investment decisions. That means you accept the risk of making bad decisions, but you also benefit from making good decisions. You get to keep “extra” profits and watch your balance grow accordingly. You’ll often be able to generate a substantially greater nest egg in a 401k than you would receive from a pension plan.
In a pension, your employer makes the decisions and accepts the risk of making bad ones. If they don’t choose wisely and there are insufficient funds to pay your promised benefit, the employer will have to pay you out of their own pocket. But if they make really good decisions, they enjoy the extra profit; they will not share them with you.
Pension vs 401k | Withdrawal Options
When reviewing pensions vs 401ks, it’s important to note that both will provide options on how you take your retirement benefit. There are a lot of possibilities here, but we’ll cover the most common options – lump sum and monthly income.
Lump Sum Option
Your retirement account is worth something; there will be an account “balance” you can see. In a 401k, it’s more obvious because you’ve been building the account during your retirement, and you’ve been able to watch your account balance grow depending on how you’ve invested the money. When you retire, your account balance should not be a surprise.
You can take that entire balance and roll it over into your own personal retirement account. These are called Individual Retirement Accounts (IRAs). You can open an IRA account at almost any bank or brokerage firm. Once you’ve opened your IRA, you can instruct your employer to rollover your 401k into that account. As long as you roll over your retirement account, it is not taxable.
Now, you’ll be able to manage your IRA and choose investment options, just like you were able to do in the 401k when you were working for your employer. You do not have to take withdrawals, but there is a time when you are allowed to take them, and there is a time when you must take them.
You may start withdrawing when you are 59 ½ years of age and, typically, have separated from service from the employer who provided the 401k. There are exceptions in some plans, allowing you to withdraw if you’re 59 ½ and still working, but ask your employer if your plan allows that.
You must start withdrawing when you are 72. The government calls this the Required Minimum Distribution (RMD) age. The government requires that you withdraw a certain amount each year from 72 on. The amount changes each year and usually increases depending upon your account’s balance each year and your age. The withdrawals are considered regular income and are subject to income tax depending on your deductions and other tax considerations.
In a pension, your “balance” is a little more difficult to determine, but you do have a “balance,” and most of the time, you will receive the option to take a lump sum distribution. Your “balance” in a pension is the present value of the benefit the employer promised to pay. Determining that is very complicated, and employers hire actuaries to make that calculation. You should receive an estimate of your “balance” each year. An actuary will confirm that estimate when you retire. However, it shouldn’t be dramatically different than the estimates you were given each year.
Monthly Income Option
Instead of taking a lump sum from your 401k or your pension, you should be allowed to receive a monthly payment instead. If you choose this option, you are accepting the risk that your employer – or someone they hire – will manage your retirement nest egg well and that they are financially strong enough to continue making payments to you as agreed, even if they make some poor investment decisions.
The core component of this option is that you agree to give up the balance in your account in return for receiving a commitment that they will make monthly payments as agreed. Under most circumstances, the primary benefit of this option is the continuity of the monthly payments.
The length of time you will receive monthly income depends on the selection you make. Most retirement plans will allow you to choose one of several types of monthly payment plans. Here are the most basic ones:
Single-life
The single-life option provides a set monthly benefit for as long as the beneficiary (usually you) lives. If you live 5 years, then payments stop after your death, and your spouse/heirs receive nothing more. If you live a really long time, the payments continue for your entire life. The point is that after your death – whenever that is – payments stop.
Joint-life
The joint-life option provides a set monthly benefit for as long as either of the beneficiaries (usually you and a spouse or someone else you select) lives. If you live for 5 years, the payments continue so long as your beneficiary (say, your spouse) lives. Payments continue until both you and your selected beneficiary have passed away.
Period Certain
The period certain option provides a set monthly benefit for a set period of time, regardless of how long anyone lives. You’ll receive several choices (5 years certain, or 10 years certain, etc.). Let’s say you pick 5 years certain. If you pass away in 3 years, payments will continue for 2 more; but on the other hand, if you live for 7 years, you’ll only receive payments for the first 5 years. Payments stop when the number of years selected has lapsed.
Life and Period Combined
The life and period combined option is a blend of the ones above. You get to pick one or two options BUT also pick a guaranteed time that those benefits will continue. As you can imagine, there are a lot of possible combinations. As an example, let’s say you pick joint life and 10 years certain. This means that benefits will be paid for as long as both you and your beneficiary live, BUT the benefits will continue for a minimum of 10 years. If you live 5 years and your beneficiary lives another 2, that would be 7 years total.
In our example, benefits would continue to be paid for 3 more years. On the other hand, if you or your beneficiary both only live 12 years, then benefits would stop when you both have died because your deaths were after the time period you selected. The point here is that you, or your heirs, receive benefits for the longer of the beneficiaries’ lives or the time period selected.
Based on the payment option you select, your benefit amount will change. Check with your employer and ask for a full list of your retirement benefit payment options. You need to be aware that if you choose one of the monthly income payment options, you cannot change your mind once you’ve made that decision. Once you decide on an income option, that decision is set in stone except under the most extreme exceptions.
Can You Have Both a Pension and 401k?
Technically, you can have both a pension and a 401k plan. Having both is very rare, but there are occasions when an employer offers both or has provided a pension plan but switches to a 401k. In these instances, the employees would retain an “old” pension benefit and would enjoy a “new” 401k plan in which they can make contributions.
Private and Public Sector
You’ll often hear 401k plans referred to as private sector plans, and pension plans referred to as public sector plans. This is not technically correct. A private employer (anyone except the government) can provide either a 401k or a pension plan, or both. A public employer (typically a government agency) can provide either. They usually do not provide both.
You may hear these terms because it is more common for private employers to offer the 401k, and it is more common for public employers to provide the pension. But, again, either type of employer can offer either type of retirement plan.
Avoid Mistakes, Get Help
Reviewing pension vs 401k plans lends itself to a lot of decision making. All of these different decisions provide a lot of ways to make mistakes. Depending on the type of retirement plan you have available, you will be asked to decide one, some, or all of the following:
- How much should you contribute?
- How should you invest your money?
- What should you do if the market turns bad?
- Should you take a lump sum or monthly income benefit?
- Should you rollover your lump sum or monthly benefit?
- How should you structure a monthly income benefit?
- How do you protect your retirement nest egg after you retire?
Each of these questions pose risks, but they also offer potential rewards. It is critically important that you make the right decision for each one and regularly monitor your retirement plan. This can be overwhelming. There is so much incorrect information (sales hype) out there that makes it easy to make the wrong decision. These decisions can have disastrous consequences to your long-term future.
We strongly advise seeking help to make these decisions. Please don’t just trust anyone you talk to; certainly, not just a next-door neighbor or a golfing buddy. Even some “advisors” are nothing more than product salespeople. You need to get advice from an objective advisor, from someone who isn’t trying to sell you a product, an annuity, or life insurance.
First Financial Consulting is a fiduciary, and we have been providing 100% objective advice for more than 40 years. We’d love to chat with you about any concerns or questions you have.
Greg Welborn is a Principal at First Financial Consulting. He works with individuals and privately-owned businesses on financial planning issues including investment, retirement, and tax planning, among others.
Greg Welborn is a Principal at First Financial Consulting. He works with individuals and privately-owned businesses on financial planning issues including investment, retirement, and tax planning, among others.
