Pension vs. 401(k): What’s the Difference?

Employers offer loads of different benefits, but retirement plans are among the most valuable. After all, retirement plans help workers set aside enough money to make sure they can enjoy a comfortable retirement.

You may have heard of both 401k plans and pensions. Both can be solid ways to fund your retirement, but they operate quite differently. Bearing that in mind, it goes without saying that each retirement plan goes hand-in-hand with its own unique set of pros and cons.

In this guide, we’ll explain what pensions and 401ks are, the differences between the two retirement plan types, and the advantages and disadvantages of each plan.

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What is a Pension?

A “pension” is a retirement plan where your employer provides you with guaranteed monthly income for the rest of your life once you’ve retired.

How do pensions work? 

In its simplest form, employers use a pension plan to set money aside over time and invest that money on their workers’ behalf to generate a return. 

When you reach retirement age, your employer will use those funds to provide you with regular payments to fund your golden years. This type of basic retirement plan is called a “defined benefit plan” because employees are guaranteed a specific benefit as defined in the plan.

This is probably the definition of “pensions” that your parents or grandparents will have taught you because defined benefit plans were common in the 20th century. But defined benefit plans have started disappearing ever since the 401k plan was introduced.

Now, government bodies and other public sector entities like schools and law enforcement tend to be the only major employers that offer traditional pensions.

What is an SEP (Simplified Employee Pension)?

Before we dive right into 401ks, let’s backtrack for a second and talk about Simplified Employee Pension (SEP) plans.

SEP plans are like traditional pensions, but there are a couple key differences, so don’t let the term “pension” fool you. 

Just like an ordinary pension, SEP schemes enable an employer to set money aside for employees. SEP accounts don’t have start-up or operating costs, and they let companies contribute up to 25% of an employee’s pay toward their pension.

SEP accounts also tend to have really high contribution limits.

Unlike a defined benefit pension plan, SEP plans let employers make variable contributions. 

That means if a business is booming in 2021, an employer might make a huge contribution toward each employee’s plan. But if business grinds to a halt in 2022, the contribution that year could end up being tiny by comparison.

For some employees, that uncertainty could make it harder to plan for retirement. But for sole proprietors or very small businesses, that added flexibility gives owners more peace of mind regarding the sustainability of starting a pension scheme.

What is a 401k?

When it comes to retirement plans in the U.S., the 401k is definitely king.

A 401k is a retirement plan that allows you to set money aside from your paycheck each month to invest in a nest egg you can use when you’re all done working. 

You’ll also sometimes hear a 401k plan called a “defined contribution plan” because you aren’t guaranteed a set income level. Instead, it’s on you to save money in the plan.

There are a few major benefits you’re going to get with a 401k. All the contributions you make to a 401k plan are pre-tax — which means the money you put into your 401k doesn’t count toward your taxable income for the year.

The money you’re placing into the account also grows on a tax-deferred basis, so you won’t have to pay any taxes on the cash until you start to withdraw it in retirement. When you start making withdrawals, they’ll get taxed at the ordinary income rate.

To take money from a 401k, you’ll need to wait until age 59. You’ll also be required to accept Required Minimum Distributions as defined by the IRS starting at age 72. For reference, a Required Minimum Distribution is just a minimum amount that U.S. tax law says you need to take out of your 401k annually.

In terms of contribution limits, most workers are allowed to contribute up to $19,500 per year. This was the IRS limit in 2021, but the amount increases most years for inflation. 

If you’re over age 55, and you didn’t always max out your annual contributions in the past, you can make additional catch-up contributions of $6,500 per year.

Although 401k plans place most of the responsibility on employees to save, a lot of employers do offer matching bonuses of either 50 cents on the dollar or dollar-for-dollar, usually up to a certain amount. 

There will normally be a cap on employer contributions that represent a small percentage of your salary, such as a 3% match. 

For example, if you make $50,000/year and make contributions into a 401k, your employer will contribute the same amount, up to $1,500 for the year (3% of $50,000 = $1,500). 

This enables you to boost or even double your retirement savings — it’s essentially free money.

Pension Pros and Cons

Pensions may be fading from employer retirement offerings, but they do still offer plenty of benefits if you’re able to land a job that still offers one. There are a couple of drawbacks you’ve got to be aware of, too.

To help you make an informed decision, we’ll quickly break down the pros and cons of traditional pensions.

Pro: Pensions are a guaranteed income for life

The most obvious pension benefit is that you’re going to get a set amount of monthly income for life after you retire.

As a result, a traditional pension means you’re never going to “run out” of money — which is a possibility if you end up with a 401k. 

If you’ve got a relatively modest lifestyle, the combination of your pension income and Social Security could be enough to cover most of your expenses in retirement.

Pro: You can keep more of your paycheck now

If you’ve got a traditional pension, your employer does all the investing for you. You don’t have to take money out of your paycheck to contribute to your retirement plan.

It does mean you’ll have to pay more in taxes now, and you may owe taxes later. But you’ll end up with more money in your paycheck overall in the end than if you had a 401k.

Con: Pensions may not cover all expenses

Unfortunately, pensions aren’t flawless. While pensions offer guaranteed income, they won’t necessarily cover all your expenses in retirement.

As political pressure and costs mount, there’s a legitimate concern that Social Security payments are unsustainable in the long term. 

Because you can’t control how much money is placed into your pension, that means you’re unable to predict whether you’ll have enough to maintain your existing lifestyle in retirement.

To cover all your bases, you may need to seek alternative methods of saving for retirement, such as opening an individual retirement account (IRA) or a taxable brokerage account.

Con: Pensions can be restrictive

It’s important to note that pensions can be fairly restrictive regarding eligibility and portability.

For example, you generally need to work for an employer for five to seven years before becoming eligible for a pension plan. 

Some employers or state governments have even longer eligibility periods. Michigan requires at least ten years of service and potentially more, depending on the employee’s situation.

But even if you work for long enough to qualify for a pension, it may not be fully vested by the time you leave the company or retire — meaning you’ll only get part of it.

401k Pros and Cons

The more popular option among employers is 401ks. 401k plans may sound less preferable for workers because they make employees responsible for their own retirement savings.

But there's a reason 401ks are so popular. To help you understand why, we’ll explore a few of the 401k’s biggest pros and cons.

Pro: 401ks offer more control than pensions

If you’ve got a 401k plan, you have more control over your investments. 

If you have an aggressive investment style and want to generate higher returns, a 401k enables you to place bigger contributions into your account. Then once you get closer to your retirement, you might hit a more conservative allocation style and will want to be more cautious with your investments.

It’s important to note that 401ks don’t let you invest in whatever you want. But they tend to offer several investment options, so there's more wiggle room to match your risk appetite.

Pro: Employers may offer a matching bonus

Although 401ks put the responsibility on you, most employers still help out by offering a matching bonus. This is essentially free money because your employer will usually match your contributions 50 cents on the dollar (or dollar-for-dollar) to top up your 401k even more.

For example, imagine you earn $5,000 per month. Your employer offers a dollar-for-dollar match up to 6% of your salary — which is $300 each month.

That means you can get up to $300 for free in your 401k every month if you contribute $300. Over a 40-year career, assuming you’ve had no salary change at all, that’s $144,000 worth of free money. Not bad, right?

Pro: 401k plans are flexible

Most employers will let you open a 401k either the day you begin working there or after a short probationary period. Either way, you’ll get to start saving way before you’d ordinarily qualify for a pension plan.

401k plans are also easier to take with you if you move jobs. It’s pretty simple to roll over a 401k into a new 401k or an IRA and continue enjoying tax-deferred growth.

Likewise, 401k plans also let you take out loans against them if you’re strapped for cash. Pensions don’t offer this facility — and you’ve got to be pretty careful using it. But it can be a real lifesaver if you run into a financial emergency.

Con: 401ks aren’t as stable

Unfortunately, with increased choice comes less safety and stability.

The viability of your 401k plan depends on how much you and your employer contribute, as well as how the market performs over time. It’s also worth noting that you're responsible for choosing your 401k’s investments, which may or may not end up performing as well as you want.

What Other Retirement Plan Options are There?

Although traditional pensions and 401k plans are two of the most popular retirement options, they are other investment vehicles out there designed to help you save for your golden years.

For example, an increasingly popular vehicle is the Roth IRA. 

A Roth IRA lets you make after-tax contributions, and then all the withdrawals you make after retirement are tax-free.

Roth IRAs are also flexible. Unlike other savings instruments, you can repurpose them. For example, you could set up a Roth IRA to save for a child’s higher education — then repurpose it for retirement after they graduate college. 

You should bear in mind that Roth IRAs have relatively low contribution limits. In 2021, the limit for under 55s was $6,000 per year. For those over 55, the annual contribution limit is $7,000.

Alternatively, you could go for a traditional IRA. 

A traditional IRA works pretty much the same as a Roth IRA and has the same contribution limits. The key difference between a Roth IRA and a traditional IRA is that a Roth IRA lets you put money into an account after you’ve paid taxes on it. You can then withdraw from your account tax-free after retirement.

Traditional IRAs are the opposite: you can put money into your IRA tax-free, but then you’ll be taxed at the point of withdrawal.

How do I Choose the Right Plan for Me?

With all these options available, it’s easy to get a bit confused about which retirement plan you should prioritize.

Above all else, it’s important to note that you might not get to choose. You may get locked into a traditional pension if that’s what your employer provides, or you might be encouraged to set up a 401k. 

But if you're given a choice, it’s important to weigh the pros and cons of each option and think about what’s important to you.

Consider the amount of flexibility and control you want to have over your retirement plan — but also the stability you’re going to require. 

Remember: each retirement plan comes with its own set of pros and cons. Think carefully, do your homework, and don’t be afraid to ask for professional advice.

Conclusion

No two workers are 100% alike, so the perfect pension plan for you might not be perfect for everyone. But it’s important that you carefully consider your options and make sure you’ve got all your bases covered.

After all, you don’t want to mess around with the financial future of you or your loved ones.

Want to learn more about pensions and investment? Check out the EarlyBird blog for more tips on how to make your money work harder.

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