Pension vs 401(k): Side-by-Side Comparison

Many retirement plans exist to help you save for the future. When it comes to a pension vs. a 401(k), you may not have a choice. But if you do, it’s important to understand their differences and similarities. (Especially if your career choices hinge on your retirement options!)

What is a pension plan?

Pensions are employer-sponsored and funded retirement plans. These “defined-benefit” plans guarantee workers a minimum level of income in retirement. To meet this promise, employers must set aside and invest money for their employees.  

Pensions have fallen by the wayside in recent years. As of March 2023, just 15% of private-sector workers could access these plans. That’s a fraction of the 67% of employees with access to defined-contribution plans, like 401(k)s. Still, they’re common in government jobs, and some larger employers offer them.

How pension plans operate

To achieve the promised defined benefit, employers set aside money for their employees. This money is pooled and invested in a pension fund. The investment earnings cover employees’ retirement payouts. If the fund underperforms, the company may be on the hook for any payment deficits. 

At retirement, employees may have the option of a lump-sum distribution or monthly payments. Some pensions also pay survivor benefits if the pension earner passes first. 

Funding structure of pensions

Pension plans require employers to fund most or all of their employees’ retirement payouts. Some plans may allow (or require) employees to make contributions, too. 

Importantly, most pension funds must “vest” before an employee qualifies for benefits. Usually, employees have to stay with a company for 5-7 years before they’re vested. 

What is a 401(k) plan?

A 401(k) is an employer-sponsored retirement savings plan. Employees choose how much to contribute (up to annual limits set by the government), and this money is typically invested in a selection of mutual funds, stocks, or bonds.

In recent decades, 401(k)s have replaced pension plans as the primary retirement account. Like pensions, 401(k)s offer financial and tax benefits to invested employees. 

How 401(k) plans operate

401(k) plans put employees in charge of funding their own retirements. The money is invested in a fund or selection of funds, depending on the program offered. The funds are managed by a company-selected investment firm. Employees can usually choose from a limited selection of funds offered by the firm. 

Two basic types of 401(k)s exist: Traditional and Roth. With a traditional 401(k), you invest pre-tax dollars into a tax-deferred account. That means you lower your annual income now, but must pay taxes on all withdrawals in retirement. Roth 401(k)s tax your contributions upfront, but you don’t have to pay taxes on retirement withdrawals. (Even on capital gains.) 

Funding structure of 401(k)s

401(k)s are primarily or solely employee-funded, depending on the company offering them. The money comes out of your paycheck and may or may not be taxed upfront. (Based on whether you have a Traditional or Roth account.)  

Some companies offer matching contributions to employee 401(k)s. For every dollar you contribute, they’ll contribute a set amount, usually up to 2-5% of your annual pay. But most employers don’t contribute to your 401(k) if you don’t. That leaves you on the hook for saving for retirement first.  

Key differences between pensions and 401(k)s

Pensions and 401(k)s share several similarities. They’re both employer-sponsored retirement accounts. They also both offer tax advantages and may provide some degree of employer contributions. But their differences matter hugely. 

Employer contributions

Pensions require employers to provide most or all the funding. Employees may be allowed (or required) to contribute. However, employees rarely fund the bulk of their own pensions.  

By contrast, 401(k)s are almost always funded by employees first. Employers may or may not match employees’ contributions (to a point). It’s rare for employers to toss in money if an employee doesn’t contribute first. 

Payment structures and payout options

Pension payout amounts depend on factors like your age, salary, and length of service. Most pensions offer a lump-sum or annuity payout structure. (Some offer both.) 

Lump-sum pensions pay retirees their entire pension upfront. You’re then responsible for saving, investing, or spending wisely through retirement. Annuity pensions make regular monthly payments until the pensioner passes away. Some pensions also pay benefits to survivors if the pensioner passes first. 

With a 401(k), you’re responsible for structuring your withdrawal payments. After you reach retirement age (59.5), you can withdraw as much as you need (or want) penalty-free. If you run out of funds, you’ll have to rely on other funding sources to get through retirement. 

Risk and investment management

Private pensions put the bulk of the investment risk and responsibility on companies. Employees don’t have to choose assets or rebalance their portfolios. But you’ll have to trust the fund manager (and the market) to work in your favor. 

Most private companies insure pensions through the Pension Benefit Guaranty Corporation. This insurance covers most or all of your pension payment if your employer can’t pay out or goes bankrupt. 

Public pensions also carry the investment responsibility. Unfortunately, they’re often underfunded and not subject to the same insurance requirements. As a result, public pensioners may face smaller payouts in retirement. 

401(k)s work quite differently. Private companies contract investment firms to offer a small range of retirement options. These may include mutual funds, ETFs, or annuities. However, these funds don’t offer any guarantees or insurance. That leaves employees on the hook if the market crashes or underperforms. 

Portability and mobility

Pensions tend to be fairly immobile. If you move to another company, your pension often stays behind until you retire. If you’re not vested, you’ll likely lose any employer contributions. Some pensions may offer buyouts or transfers to another pension plan. 

While 401(k)s don’t move between employers, the money within them can move fairly easily. (Note that some employers set vesting requirements for their contributions. That said, your contributions remain all yours!) If you change employers, you can usually roll the money into another 401(k) or rollover IRA to keep it with you.  

Pension vs 401(k): Pros and cons

All retirement plans have their pros and cons. This is how pensions vs. 401(k)s stack up. 

Pros and cons of pension plans

Employer-funded pensions make employers responsible for their employees’ retirement. Setting benefit formulas up front lets employees know they’ll have income later. (Especially for private, insured pensions that make annuity payments.) 

But not all employers offer pensions, and employees rarely have input in a pension’s investments. Uninsured and underfunded pensions may pay reduced benefits, jeopardizing your retirement plans. That’s especially true for public pensions that lack insurance requirements. You also can’t withdraw funds early or adjust your monthly payments. 

Pros and cons of 401(k) plans

401(k)s offer benefits like employer matching and high contribution limits. Plus, you can often choose between Roth or Traditional accounts. Together, these benefits give you more choice and flexibility over your retirement savings. The tax benefits can even reduce your annual income now, offering short-term benefits. 

But since 401(k)s are primarily employee-funded, you’re on the hook for your own retirement. You also have limited investment options and no insurance to protect you. That leaves employees with no guaranteed income in retirement. And while you can structure payouts around your lifestyle, early withdrawals carry penalties. 

Emerging trends in retirement plans

Some retirement plans “blend” aspects of both defined-benefit and defined-contribution plans. While not available everywhere, they offer unique benefits. 

Cash balance pension plans

Cash balance pensions have a distinct funding structure. Every employee receives a hypothetical “account.” Employers pay annual “credits” into this account. The credit amount is made up of two parts:

• A set percentage of their yearly compensation (e.g., 5% of annual wages)
• An interest payment paid on the account balance (e.g., 3% of the account balance)

These credits continue until the account balance reaches the target account balance. Then, at retirement, the employee may receive a lump-sum payout or monthly annuity payments. 

Cash balance plans vs traditional pensions and 401(k)s 

Cash balance pensions operate similarly to pensions. They’re employer-funded and set predetermined benefits amounts. Plus, investment fluctuations don’t impact your final benefit payout. 

Unlike traditional pensions, though, your defined benefit isn’t a monthly payment. Instead, the account sets a hypothetical total account balance. (E.g., $1,500 per month vs. an account balance of $150,000.) 

Some employers also offer cash balance pensions with hybrid 401(k) features. This may mean that the employee can contribute to a 401(k) in addition to receiving their pension benefits. But unlike regular 401(k)s, employers remain responsible for the pension part of the plan. 

Which retirement plan is right for you?

Unlike some other retirement decisions, you may not get to choose which account you get. As private pensions disappear, most employees are left with 401(k)s or IRAs. (Though many public-sector employees still have pensions.)  

But you may find yourself in the position of choosing between the two. (For instance, if the difference between two job offers comes down to their retirement options.) In that case, you’ll want to carefully weigh the pros and cons against your:

• Risk tolerance
• Starting and future potential pay scale
• Individual goals

Pensions offer guaranteed payments and put the risks on the employer. However, you have limited control over the plan’s investments. Your payout is also limited by a preset formula. If you work in the public sector, you may end up underfunded in retirement. 

With a 401(k), the investment performance and payouts are NOT guaranteed. You may enjoy having more choice over your investments, contributions, and withdrawals. That said, you’re responsible for funding, account losses, and money management in retirement. 

At the end of the day, there’s no “right” retirement plan for everyone. There’s only the “right” choice for your goals, needs, and risk tolerance.