Comparing the 401(k) vs. pension plan 

No financial advisor or investor would argue that retirement planning is a crucial part of financial planning. Everyone is going to retire sometime, so knowing and choosing the right type of retirement savings or retirement income vehicle for your client’s needs is of utmost importance.  

As retirement means being less productive and therefore earning less (or even not at all), your clients will want to build an ample retirement nest egg. One that can provide a guaranteed income, if possible.   

Among the many retirement choices, we’ll compare two of them: the 401(k) vs. the pension plan.  

In this article, InvestmentNews gets into the differences between the 401(k) plan and the pension plan and provides some insight into important questions about them. For instance, is a 401(k) better than a pension plan? Can you have a 401(k) and a pension plan? Read on to find out.  

Introduction to the 401(k) and pension plan  

The type of retirement plan or retirement policy that your client’s employer has will largely determine which of these retirement tools are available to them. In most cases, it’s more likely that your client will have a 401(k) plan vs. a pension plan.  

Many employers offer and more employees prefer the 401(k) because of the many benefits it offers. Perhaps the most beneficial feature of the 401(k) plan is the employer match, apart from other advantages like deferred taxes.  

Highlighting the 401(k)’s popularity vs. the pension plan is not to discredit the latter. Though outdated and not often offered by companies in the private sector nowadays, those who receive a pension will say that this retirement tool has some merits. For starters, the pension plan is designed to provide a guaranteed income for life – and this is transferable to the pensioner’s beneficiaries after the pensioner dies.  

What is the 401(k)? 

Named after the section of the US Internal Revenue Code 401(k), this is an employer-sponsored retirement savings plan. Sometimes referred to as a defined contribution plan, the 401(k) account works by having its owners contribute a portion of their salary to it every payday.  

Plan holders must also decide which investments the money in their 401(k) goes into, and how much of the savings go into each investment. This contrasts with the pension plan, whose investments are mostly controlled by the employer who offers it.  

Apart from the relative freedom of choosing which investments the savings in the 401(k) plan goes into, these are the main reasons why the 401(k) is so favored:  

• the employer match feature 
• tax-deferred gains on the account 

Employer matches are what make the 401(k) so revered by advisors and loved by their investors. In a 401(k) match, account owners have a portion, if not all their contributions, matched by their employers. This can be as much as an additional 3% to 6% of their annual salary put into their 401(k). Some advisors would go as far as to say that the employer match is basically “free money”. 

What is the pension plan? 

The pension plan is a much older predecessor of the 401(k) plan. Before the 401(k) was introduced in the late 70s, many employees had either the government-issued private pension plan or the Cash or Deferred Arrangement (CODA) plan for their retirement.  

Also called defined benefit plans, the pension plan is an employer-sponsored plan designed to create a retirement savings fund and provide pensioners with a monthly check when they retire. Pension plans typically give plan owners payments for life, or as a lump sum if they choose. The amount of money they receive is based on: 

• how much the retiree earned 
• how old they are 
• how many years they worked at the company 

As for taxes, pension income is taxed at the regular income tax rate. 

What are the similarities and differences between the 401(k) vs. pension plan?  

There are a few similarities between the pension plan and the 401(k). Their most notable similarity is that both the pension plan and 401(k) are employer-sponsored. Contributions to both plans are not taxed, and neither is the growth on their investments. Both plans have their taxes deferred until the plan holder withdraws money upon retirement.  

Both plans are meant to provide a source of retirement income. The age at which a retiree can receive distributions or monthly payments without incurring penalties differs. Here’s a breakdown of these plans’ similarities and differences:  

 Which is better, the 401(k) plan or a pension plan? 

Objectively speaking, both plans can be very beneficial to retirees, but the pension plan can be considered the better option of the two. Retirees can receive their pension benefits as monthly payments for the rest of their life.  

The amount that a retiree can receive from their pension is usually based on: 

• average earnings during their years of service 
• number of years they worked in the company 

Whatever amount they receive will be based on these criteria, regardless of how they performed at that job.  

Technically, it’s the 401(k) plan that “killed” and replaced the age-old pension plan, which is likely why you still see people compare the two. This video explains why the 401(k) succeeded vs. the pension plan. You’ll even hear Ted Benna, the Father of the 401(k), recount how he successfully created and pitched the first 401(k): 

Can I have both a 401(k) account and a pension plan? 

Yes, it’s possible to have both a 401(k) and a pension at the same time. Although it’s unusual for someone to have both from a single employer, there are many employees in this situation.  

How does this happen? Typically, an employee gets a 401(k) from a previous employer, then they get a pension plan from their new employer, or vice-versa. Should this be the case, the employee can transfer their 401(k) to their new employer, while their pension plan benefits are already set.  

Can I have multiple 401(k) plans?  

Yes, you can have multiple 401(k) plans, but this is not recommended. Your 401(k) plans can stack up if they are from former jobs and you didn’t choose to do any of your options. When you leave a job, here’s what you can do with your 401(k) plans there:  

• keep it with your previous employer 
• roll it into an IRA 
• roll it into a new employer’s plan 
• cash out the money from the 401(k) 

If you keep your 401(k) with your previous employer, you can no longer contribute to it, so your former employer doesn’t have to give you the employer match. A 401(k) left with a previous employer may still grow, depending on the investments.  

Leaving your 401(k) is not a good option to do with every employer – you can end up with several 401(k) plans that you may forget about by the time you retire. The worst-case scenario is if you don’t get the money for retirement, or your heirs remain unaware of their existence.   

Rolling it into an IRA or your new employer’s 401(k) would be better options. Cashing out the money in the plan may not be a good idea, since you must pay taxes on the withdrawal. Withdrawing all the money from a 401(k) plan may also incur additional penalties if you do it before you reach the age of 59½.  

What are the disadvantages of a 401(k)? 

The 401(k) plan can be a good retirement vehicle, but it has its share of drawbacks: 

Fees may be high 

Due to the many investment options, some plan holders may make the mistake of choosing investments that have high fees. Employees are advised to check their 401(k)’s plan document to know which investments are available to them and check the fees of the investments. 

It’s also the employer’s duty to provide investment options for their 401(k) that charge reasonably priced fees. The employer can be liable for fiduciary breach if they fail to give their employees good investment options.  

A recent lawsuit against telecom giant Qualcomm could set a precedent for future 401(k) cases. The suit alleges Qualcomm misused employee contributions. The legal battle highlights the importance of clear 401(k) plans, some experts say.https://t.co/ItgMYKNBjR

— InvestmentNews (@investmentnews) June 5, 2024

There may be a vesting period to keep employer matching contributions 

Some employers may have certain conditions on their 401(k) plans. One such condition is the vesting period. This is the minimum number of years that an employer requires to stay in the company before they own 100% of their contributions.  

Employees should check their employer’s summary plan description to know if there is a vesting schedule and follow it to become fully vested. If there is a vesting schedule, this can take an average of 3 to 5 years. There are some companies that offer instant vesting. 

There is a penalty for early withdrawals  

401(k) plan holders who may need money in an emergency without any other fund sources can worsen their financial situation. Should they withdraw some or all the money in their 401(k) before they’re 59½ years old, they must pay a 10% early withdrawal penalty. If they ever find themselves in a situation where they have no other choice, they should try to withdraw from their 401(k) wisely. 

What are the disadvantages of the pension plan?  

The pension plan has its share of drawbacks as well. The benefit of giving retirees a monthly paycheck for the rest of their lives is advantageous, but here are some issues to consider:  

The employer has full control over the investments 

There is the risk that the pension plan would not grow as much as a 401(k) plan. That said, the earnings of a pension plan may not be all that great as they are under the control of the employer. Employees will unfortunately have to place their complete trust in whatever ability their employer has in choosing investments and hope the gains will be significant.  

The payouts may not be as big 

Since the pension plan’s investments are under the control of the employer, the pension fund may not be as large as employees would like by the time they retire. Other factors that can heavily influence the pension payouts are:  

• the individual employee’s years of service 
• the employee’s average salary during their employment 

• when they choose to retire 

These factors at least mean that an employee has some control over their pension payouts. They can get a sizable one if they stay for as long as possible with the company, get as many raises and promotions as they can, and retire at their normal retirement age or later to receive a bigger amount. 

401(k) vs. pension plan: is it a matter of choice? 

Choosing between a 401(k) vs. a pension plan is not always a matter of choosing one over the other. The answer will depend on the individual investor’s financial goals, time horizon, and risk tolerance.  

While both retirement accounts can serve as tools for building a retirement nest egg, it’s ultimately up to the individual investor which would suit their needs and personal financial circumstances the best. Investors should also consider that they may not be as healthy by the time they retire, so they should think about other investments to bolster their savings and retirement income.  

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