Skip to Content
Older couple dancing at party symbolizing that they are enjoying retirement.
Retirement Planning

Pension vs 401(k): what's the difference?

Pension plans, which are funded by your employer, are increasingly being replaced by 401(k) plans, which are employee-funded. Learn how these plans work and what they mean for your retirement.

There are many different financial plans that can help you save for a comfortable retirement. However, since all retirement plans have their own features and benefits, it's not always easy to know which one is which. That's why it's best to compare as many different plans as possible in order to make the right choice for you.

So what are pensions plans and 401(k)s, and what are the key differences between the two?

Pension plans are defined benefit plans that can offer a great deal of security, providing lifetime income throughout retirement. However, these plans are increasingly rare and mostly found in government agencies. Today, 401(k)s are the most prominent type of retirement plan for most private sector companies, offering employees an opportunity to save a portion of their income, tax-deferred, investing it in one of many select program investments. Often, companies will match a portion of the employee’s 401(k) contributions. Read on for additional details and pros and cons of each type of plan.

What is a pension plan?

A pension plan (also referred to as a defined benefit plan) is a retirement account that is sponsored and funded by your employer. Retirement benefits are based on a formula that includes factors such as your salary, age, and the number of years you have worked for that company. For example, your pension benefit might be equal to 1% of your average salary for the last five years of employment, and then times your total years of service. Over the years, your employer makes contributions on your behalf and promises to make regular, predetermined payouts every month when you retire.

Pros

  • Typically, pensions are a defined benefit program, which means that you will begin receiving income at the time of your retirement.
  • In many pension programs, payout runs for life, providing a greater degree of security, no matter how long you live.

Cons

  • Since the company is in control of the money, you won’t have a say in how it’s invested.
  • If you change jobs, you may forfeit your right to your pension since the money is not portable as it is with a 401(k).
  • If the company fails prior to your retirement, your pension may not be honored.

What is a 401(k) plan?

A 401k plan is a retirement account that's made available to employees who wish to save for their retirement (provided their employer offers a plan). In this case, it's the employer that holds back a part of your salary (tax-deferred) and invests those dollars on your behalf. Some employers are even willing to match the contributions made by their employees with their own money. Since 401(k) plans are meant to encourage you to save for retirement, there are heavy tax penalties imposed for early withdrawals (before age 59½).

Pros

  • With a 401(k) plan, you may choose from a list of available investments, giving you control over how the money is invested.
  • You may roll over your money if you change employers over time.

Cons

  • Your contributions are invested in market securities, so there is some volatility associated with 401(k) plans.
  • It’s possible to access the money and use it for emergencies or other uses prior to retirement, which may leave your retirement savings drained prior to retirement.
  • A 401(k) is a defined contribution plan, so your account could be depleted during retirement.

Pension plan vs 401(k)

A pension plan is funded and controlled by the employer, while a 401(k) is primarily funded by the employee, who may choose how the money is invested. Some employers will match a portion of your 401(k) contributions. A 401(k) allows you control over your fund contributions, while a pension plan does not. Pension plans guarantee a monthly check in retirement a 401(k) does not offer guarantees. However, 401(k)s are portable, meaning you can roll them over into another account should you change employers one or multiple times. Pensions may only be available if you stay with that company through retirement. 

Pension plans have been in existence for a long time, while 401(k)s are now more common. In fact, the 401(k) will most likely be replacing pension plans altogether in the near future.1 However, there are still employers who offer both a pension plan and a 401(k) plan - if you're lucky enough to be in that fortunate situation.

 

1. http://www.ssa.gov/policy/docs/ssb/v69n3/v69n3p1.html

 

WEB.1332.03.15

Arrows linking indicating relationship

Related Articles

Middle-aged African-American woman sitting in front of her laptop and intensely thinking.

How is a Roth 401(k) different from a traditional 401(k) Plan?

Learn more
Young outdoorsy couple with a snowy mountain backdrop.

What's the difference between a Roth IRA and a traditional IRA?

Learn more
Older gentleman sitting on his couch, contemplating his next move in chess

Thinking about retiring during a recession

Learn more
All Learning Center articles are general summaries that can be used when considering your financial future at various life stages. The information presented is for educational purposes and is meant to supplement other information specific to your situation. It is not intended as investment advice and does not necessarily represent the opinion of Protective or its subsidiaries.

Learning Center articles may describe services and financial products not offered by Protective or its subsidiaries. Descriptions of financial products contained in Learning Center articles are not intended to represent those offered by Protective or its subsidiaries.

Neither Protective nor its representatives offer legal or tax advice. We encourage you to consult with your financial adviser and legal or tax adviser regarding your individual situations before making investment, social security, retirement planning, and tax-related decisions. For information about Protective and its products and services, visit www.protective.com.

Companies and organizations linked from Learning Center articles have no affiliation with Protective or its subsidiaries.