401k vs Pension Plan: What’s the Difference?

29 June 2023

Retirement. It is the goal that all Americans strive for. However, to achieve that goal, they have to save an adequate amount of money.

The average American has just over $141,000 saved up for retirement.

If you are someone that is thinking about setting up a retirement fund, two options that you may hear come up are a 401K and a pension plan.

What is the difference between a 401K vs pension plan? Does either option have guaranteed income? How much does market volatility play a part in both options?

This guide answers those questions and more.

Table of Contents

401K

Let’s start by talking about 401K plans. This is an option that you have to save up for retirement which gives you more control of your funds.

The reason is that there is no required amount of money that you have to contribute to a 401K. However, depending on where you work, you may be encouraged to put more money into your 401K because of matching incentives.

Essentially, some companies will match your 401K contributions up to a certain dollar amount of a certain percentage within a calendar year. In other words, you could get free money from your employer if you are willing to put more contributions towards this.

The other good thing about a 401K plan is that you have more flexibility to access your money. You can even take out a loan and use your 401K as collateral if need be.

However, if you do take money out of this account before a set time, there are usually penalties associated with this.

On top of that, you have to think about your investment skills. You are either going to have to manage this money yourself or you may even have to hire a money manager to give you advice on how to distribute this money in your 401K.

Another con you have to think about is how long your money is going to last. If you do not fund a 401K plan properly, you may run out of money from it before you die. This can happen if you retire too early, there is sudden inflation, or you have unexpected expenses during retirement.

A 401K plan can be good for someone that wants more control of their money and someone that is looking for a little more flexibility in their retirement fund.

Pension Plan

The other option you have for a retirement fund is to help fund a pension plan. Pensions work differently than 401Ks because instead of just contributing your own money to a plan, you are contributing money to a much bigger fund.

Typically, these pension funds cover every eligible employee that worked for that company. Then, employees can start to collect their portion of the pension fund once they decide to retire.

There are prerequisites for this. The main one is that employees usually have to work for a certain amount of years for the company. There is typically a minimum amount of years they have to work to receive any pension benefits and then they have to work more years after that if they want the maximum benefits.

So, where do all of these contributions go? They go to an investment professional that manages the entire fund. Then, they invest all of the money accordingly and promise employees that contribute to the fund a certain return upon retirement.

The risk with this option is that if the company goes bankrupt, you could have reduced pension benefits or lose the benefits entirely. That is why some people consider investing in alternatives in this category as insurance.

What is the major pro to pension plans? The benefits last for life, unlike 401K plans. So, if there is sudden inflation or a sudden expense comes up, you are more likely to have the funds to cover it.

Other Factors

There are a few other factors that you should consider with both of these options.

As mentioned above, you do have more flexibility about when you can take out money from your 401K plan. However, there is a catch to this if you are not careful.

That catch is that if you take this money out before you are 59.5 years old, you could end up paying a penalty for taking money out too early. Typically, this is about 10% of the money that you are withdrawing.

On top of this, you will likely have to pay taxes on that money that you may not have had to pay when you first contributed that money to your 401K.

Another factor you are going to want to think about is insurance. This applies more to pension plans because they typically rely more on the company’s stability than 401K plans.

You need to make sure that this pension plan has some sort of insurance attached to it. If it does not, then you can lose everything that you contributed if the company goes bankrupt. Insurance minimizes your losses if this scenario occurs.