Pension vs. 401(k): Which Retirement Plan Is Best for You?

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It’s never too early to plan for retirement, but with so many options, it can be overwhelming to determine the retirement savings plan that fits you best. The first step of planning a path to retirement is understanding what each plan entails and whether or not the payout will fit your projected lifestyle. Among other options that are available, you might consider a pension plan or a 401(k) for retirement.

What Is a Pension Plan?

A pension plan is an employer-sponsored retirement savings plan, funded by your employer while you work for the organization. The employer will invest funds for you and the earnings generated will be paid out to you when you retire. Employees typically have the option to contribute funds to their pension plans.

Understanding Pension Plans

When we talk about pension plans, we’re typically talking about a defined-benefit plan. This means the employer will give a set benefit amount in retirement no matter what the earnings are on the underlying investments.

While this sounds great, defined-benefit pension plans have become quite rare as employers have started offering the less expensive defined-contribution plan instead — typically a 401(k).

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How Does Payout Work for Pension Plans?

Pensions work similarly to Social Security, which is actually a type of pension plan. The amount paid out depends on how long you worked for the company and the amount you earned during that time — just like the amount paid by Social Security, which is also determined by years of work and lifetime earnings.

Funds begin paying out regularly when you retire and typically continue for the rest of your life, but there are limits on the annual amount. Your annual payout cannot exceed the lower of the following:

  • 100% of your average compensation for your highest three consecutive calendar years
  • $230,000 (for 2020 and 2021)

Are Pension Plans Insured?

If the company goes bankrupt, most plan benefits will still be guaranteed by the Pension Benefit Guaranty Corporation, which the federal government oversees. However, public employees are the ones who are largely covered. Today, 85% of public employees are covered while just 15% of private employees are covered.

The following table shows the maximum insurance amount and annual plan limits for various retirement savings for 2021 and 2020:

Plan and Insurance Limits 2021 2020
Maximum annual payout from defined-benefit pension plan $230,000 $230,000
Maximum monthly amount insured by the Pension Benefit Guaranty Corporation for people retiring at age 65 $6,034 $5,812
Annual employee contribution limit for 401(k), 403(b) or 457 plans $19,500 $19,500
Maximum annual contributions to a defined-contribution plan (employer and employee combined total) $58,000 $57,000

Can You Transfer Pension Plan Funds?

Unfortunately, you cannot transfer pension plan funds to other retirement savings plan accounts like a 401(k) or an individual retirement account. If you leave the company, you will still need to keep that money in the pension plan from that employer.

However, a pension plan from one government organization can often be transferred to a pension plan at another government job.

The Advantages of a Pension Plan vs. a 401(k) Plan

There are advantages and disadvantages of pension plans and 401(k)s. One plan isn’t necessarily better than the other, but one may suit your needs or wants more closely. While a pension plan gives a set benefit, a 401(k) requires regular employee contributions to build up the investment. Aside from that obvious difference, there are a few other factors to consider when comparing the two types of retirement savings plans: investment choice, employer contributions and payout.

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Investment Choice

In 401(k) plans, you have more choice in what you invest in. Typically, you are given a selection of plans to choose from. While these options are still a bit rigid in that you can’t choose exactly which stocks and exchange-traded funds you want in your portfolio, you often can choose the conservativeness or aggressiveness of your portfolio.

If your funds are in a pension plan, your employer has full control of the investments the pension plan funds go into. Even after quitting, the employer retains full control of the investments until your retirement.

Employer Contribution Matching

Pension plans don’t require employee contributions, but employees are sometimes allowed to contribute under some plans. Employers will provide a set amount of funds for each worker and pool them for investments.

Meanwhile, employees must fund their 401(k)s themselves. The employer may or may not provide a “match” for employee 401(k) contributions. The average contribution match by private companies is somewhere between 3% to 6% of an employee’s annual salary.

Suppose you made $100,000 a year and contributed $10,000 to your 401(k). If your employer provided a 5% match, that means the employer would contribute another $5,000, or $100,000 multiplied by 0.05. The total contribution would be $10,000 plus $5,000, for a total of $15,000.

Payout

The payout for a 401(k) is entirely based on how much the employee contributes to their savings plan, whereas the payout for a pension is based on how long the employee has worked for the company and how much they earned.

Good To Know

Typically, there is a vesting time — a period of time you have to stay at the company as an employee to be able to receive the pension benefits.

Alternatives to Pensions and 401(k)s

If your employer does not offer a pension plan or a 401(k) plan, there are alternative retirement savings accounts. A popular choice is an individual retirement account.

One of the benefits of an IRA is that it can be tax-deferred. Another advantage is that the contributions and investments in your IRA are completely up to you and very flexible — you can invest in stocks, bonds and assets at your discretion.

With an IRA, you can withdraw your money at any time, but there are penalties for early withdrawal just as there are with 401(k)s. If you withdraw funds before age 59 1/2, you may face a 10% penalty.

Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.

About the Author

Brenda Zhang is a technology, finance and game writer with over a decade of writing experience and too many blogs to count. She has worked in biology labs, psychology labs, tech startups and big corporations. A San Francisco-based software engineer by day and an interdisciplinary writer by night, she connects her seemingly unrelated experience in multiple fields to reveal new insights.

Pension vs. 401(k): Which Retirement Plan Is Best for You?
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