Both pensions and 401(k)s are retirement savings plans, but they have many differences. When it’s time for you to retire, Social Security Retirement Benefits will cover approximately 40% of your average earnings. You can use a pension or 401(k) to make up the difference.
Overview
- Pension plans are funded by employers
- 401(k)s are funded by employee contributions
- Some employers will match a percentage of a 401(k) contribution
- Employees do not have control over pension plans, but they are guaranteed by the employer when certain conditions are met
- Pensions used to be the standard but now, 401(k)s are far more common
Employee Pension Plans
Pensions are workplace retirement benefits. They guarantee workers a monthly retirement payment as long as certain conditions are met during employment years. Companies usually require employees to work a minimum number of years in order to receive the benefit.
Pensions are calculated based on the employee’s years of work and average earnings. Although the employer has control over the pension, employees can opt-in for certain features like:
- Pension buyouts
- Early retirement offers
- Salary reductions for higher retirement payouts (SARSEP)
- Pension plan investment options
- Survivorship options
Some pensions have a voluntary investment option and may allow the employee to make additional contributions into the investment account. Pension plans with this feature may have an annual employer match, making this variant similar to a 401(k).
There are two types of pension plans: defined benefit and defined contribution.
The First Private Pension in the U.S. Was Created in 1875
The first corporate pension plan was offered in 1875 by the American Express Company to reward workers who had been ”injured or worn out” by the company’s rail, barge, and horseback delivery service. They wanted a way to ease people out of the workforce in a charitable way.
During the 19th century, the way in which American business was structured and operated underwent radical changes. Before this time, most companies were owned by an individual or single family.
As businesses grew, new administrative structures and processes became necessary. The introduction of pensions was simply a small part of a much larger corporate revolution. Early pension plans did not involve investments and included a specific monthly benefit funded entirely by the employer.
Pension Protection
Companies quickly discovered that pensions are costly. In 1893, less than 20 years after they were introduced, companies started introducing strict conditions to limit benefit eligibility.
Employees had no entitlement to early pensions. Employers could withdraw or alter the benefits at any time. The Great Depression saw many workers’ pensions disappear because they were not federally protected.
Although the Social Security Act of 1935 guaranteed retirement income to eligible US workers, private pensions were not federally protected until 1974, nearly 100 years after they were first introduced. The Employee Retirement Income Security Act required companies to put pension contributions in trust and gave workers a legal right to their benefits.
The 401(k) Was Created by Accident in 1978
In 1978 Congress passed a Revenue Act with a provision under Section 401(k). The provision allowed employees to avoid taxes on deferred compensation. Two years later, a benefits consultant named Ted Benna referred to Section 401(k) while pitching a tax-friendly retirement plan to a client.
His idea allowed employees to save pre-tax money into a retirement plan, a portion of which would be matched by the employer. Although the client passed on the plan, Benna’s employer, The Johnson Companies, ran with the idea and became the first company to offer a 401(k) option.
These days “401(k)” is synonymous with employer-sponsored retirement plans. We call these 401(k)s, but the provision under the law makes way for a variety of other pre-tax savings plans.
401(k) Retirement Plans
401(k) retirement plans allow employees to save and invest money pre-tax and take advantage of employer matching contributions. Employees can automatically save a percentage of their paycheck into the 401(k) account with most plans. The employee will match the employee’s contribution up to a certain percentage until it exceeds a preset limit.
401(k) funds can then be invested. Most employers provide 401(k) investment options through a firm that offers investment portfolios at no additional cost to the employee.
Money in 401(k) retirement plans is saved and invested pre-tax. This means that you won’t pay taxes on the funds until you withdraw them during retirement. Most plans charge penalties if you withdraw funds early.
For example, If you withdraw funds early, you will be charged a 10% penalty tax plus your income tax rate on the amount you take out because the money will be treated as income.
Employees who choose 401(k)s have a lot of control over how the plan is set up. There are several types of 401(k) plans, including:
Pensions are Becoming Less Common
According to a study by Willis Towers Watson, only 14% of Fortune 500 companies offered pensions to new hires in 2019. That number is down from 59% in 1998. Since the 1980s, pensions have declined, and 401(k)s have taken over as the most common retirement plan for covered workers.
The result is that responsibility and risk associated with retirement funds are in workers’ hands rather than their employers. Workers in the private sector now take on most of the cost and risk of their retirement investments.
Advocates for both pensions and 401(k) plans continue to debate the pros and cons.
Can You Have Both a Pension and 401(k)?
Yes, technically, you can have a pension and still contribute to a 401(k) though it is not common.
For example, you may have worked for a company that offered a 401(k) and began your retirement savings there. If you leave that company for one that provides a pension, you may opt to keep contributing independently to the 401(k) by rolling it into an IRA (a 401(k) variant).
Pensions usually require you to work at the same company for an extended period of time. Also, if a company offers a pension, it is unlikely to offer a 401(k).
Most workers in the public sector still get a pension. Those in the private sector typically have access to 401(k)s or nothing at all. A majority of workers still aren’t eligible for any employer-sponsored retirement.
The Three-Legged Stool of American Retirement
Whether your retirement is around the corner or many decades in the future, experts agree that your planning should include three things: Social Security, An Employer-Sponsored Retirement Plan, and Personal Savings. This combination should provide the funds you need to live during retirement.
Both pensions and 401(k)s satisfy the employer-sponsored leg of your retirement planning. When 401(k)s are involved, there is even further room for diversification. For example, you can max out your 401(k) employer match and save even more in a Roth IRA.
More retirement planning advice from Top Dollar:
A No-Nonsense Guide To Non-Employer Retirement Savings Plans
Should You Save For Retirement When You Have Credit Card Debt?
Money Advice for Your 50s