For some people, a pension is a route to retirement, but often it's not the only way to get there. Here’s what pensions are, how they work and options if you don’t have access to a pension plan — or if the payouts will be too small to live off of in retirement.
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What is a pension plan?
A pension plan is a retirement-savings plan typically funded by an employer. Money goes into the pension on behalf of the employee while the employee works for the organization. The employee receives regular payments in retirement. Pensions differ from 401(k)s, though both are employer-sponsored retirement plans.
Technically Social Security is a pension program, but when people talk about pensions, they tend to mean those with a company.
How pensions work: an overview
Pensions are usually defined benefit plans, where the amount you receive in retirement depends on years worked and earnings over time. In general, employers offer a pension plan as a perk to attract talent.
Here are some of their main features:
Employers usually fund them. The pool of money in a defined benefit pension plan typically comes from the employer, though sometimes employees can contribute their money to the plan if they choose.
Tenure and compensation matter. How much an employee gets from an employer’s pension plan usually depends on how long the employee works for the employer and how much the employee earns.
Payouts start when you retire. Upon retirement, the employee receives regular periodic payments, usually for life. In general, your annual benefit from a defined benefit plan can’t exceed either 100% of your average compensation for your highest three consecutive calendar years, or $265,000, that's the threshold for 2023,whichever is less. The annual dollar amounts are subject to cost-of-living adjustments.
Pensions generally aren’t portable. If you leave the company and get a job elsewhere, you may not be able to move the money into another account such as a 401(k) or an IRA. (In some cases, though, particularly with government jobs, employees may be able to transfer some or all of a pension to the pension plan at a different government job.) The money typically stays in the pension plan until you retire. In some cases and under certain circ*mstances, companies may offer employees lump-sum distributions or buyouts.
Pensions are pretty rare these days. A generation or two ago, defined benefit plans were common. Today, employer-sponsored retirement plans are typically defined contribution plans such as a 401(k), which is fundamentally different (see the table below).
You’ll probably get paid even if the company goes bankrupt. Many defined benefit plans are guaranteed by an agency of the federal government called the Pension Benefit Guaranty Corporation. That means that if the employer goes out of business or doesn’t have enough cash to pay retirees, the PBGC will step in and pay. Companies buy this insurance, and the pension plan is insured even if the employer falls behind on the insurance premiums for the coverage.
» MORE: See what the maximum Social Security payout is
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Is a 401(k) or a pension plan better?
There are upsides and downsides to each, so what’s “better” depends on your circ*mstances and what’s important to you.
A defined contribution plan such as a 401(k) lets employees (and sometimes employers) contribute to an investment account. A defined benefit plan, on the other hand, promises employees a set benefit at retirement and puts the responsibility of providing that benefit — including the investment risk — on the employer.
Another difference lies in who controls the investments available within the plan. Employees with a pension generally have little or no say in how their money is managed, and if they leave the company, they likely can't roll over the funds into a 401(k) or an IRA. Employees with a 401(k) can choose from a roster of available investments, and upon leaving are able to roll over their money into an IRA or a 401(k) at their new job.
401(k)s vs. pension plans
| 401(k) (defined contribution plan) | Pension (defined benefit plan) |
|---|
| Payouts are based on how much employee contributes and how employee invests the money before retirement | Payouts are based on how long employee works for company and how much employee earns there |
| Mostly the employee (an employer may match some contributions) | |
Who manages the investments and bears the investment risk | | |
Who has control over money before retirement | Employee can move money into another 401(k) or IRA if leaving the company (called a rollover) | Employer retains until employee retires |
| | |
What if I don’t have access to a pension plan or a 401(k)?
If that's the case, opening an individual retirement account (IRA) might be a good option. You can also roll over a 401(k) from an old job into an IRA (here's how).
An IRA is a tax-deferred or tax-free retirement savings account that many financial institutions offer. You can invest in stocks, bonds and other assets. How much your IRA earns and whether you lose money depends on how you invest. You can withdraw your money any time, but you may face a 10% penalty and a tax bill if you do it before age 59 1/2, unless you qualify for an exception.
FAQs
There are pros and cons to both plans, but pensions are generally considered better than 401(k)s because they guarantee an income for life. A 401(k) can be more aggressively managed by the individual, which could create more growth than is likely from a pension fund.
Which is better 401K or pension? ›
There are pros and cons to both plans, but pensions are generally considered better than 401(k)s because they guarantee an income for life. A 401(k) can be more aggressively managed by the individual, which could create more growth than is likely from a pension fund.
What are the disadvantages of a pension plan? ›
In contrast, a pension plan also comes with a few disadvantages:
- No control: Unlike with some other retirement plans, with a pension you don't have any control or access to your money until you retire. ...
- Risk of bankruptcy: You do run some risk if the company that holds your pension goes bankrupt.
One example is the $1,000/month rule. Created by Wes Moss, a Certified Financial Planner, this strategy helps individuals visualize how much savings they should have in retirement. According to Moss, you should plan to have $240,000 saved for every $1,000 of disposable income in retirement.
How would you compare a pension plan 401K and 403 B plan? ›
401(k) plans can be offered by for-profit companies to their employees. 403(b) plans are offered to employees of non-profit organizations and government entities. Participants in either type of plan contribute pre-tax or post-tax money through regular payroll deductions. The employer may also choose to contribute.
Why do people love pensions? ›
Traditional pensions typically offer a guaranteed monthly benefit to retirees, a steady stream of checks that continues until death. The 401(k), by contrast, offers a way for employees to build their own retirement savings, often with help from the employer.
What is the main difference between a pension and a 401k? ›
What is the difference between a 401(k) and a pension? A 401(k) is an employer-sponsored retirement account that allows an employee to divert a percentage of his or her salary—either pre- or post-tax—to the account. A traditional pension plan offers retirees a fixed monthly benefit for the rest of their lives.
Why are pension plans not common anymore? ›
“Companies started moving away from pension programs in the 1980s, mainly due to the high costs and because it is simply unpredictable to know how long the company will need to make payments to each retiree,” said Michael Arvay, founder and CEO of Marvelous Retirement Planners in Toledo, Ohio, in an email.
Why are pensions in trouble? ›
If there is any “crisis” for pension plans, it starts with the costs of paying for growing unfunded liabilities. State and local pension funds reported more than $1 trillion in unfunded liabilities in 2020. They reported just under $1 trillion in funding shortfall for 2021.
Why companies don t do pensions? ›
Traditional pension plans have been on the decline, primarily due to the economic strain they place on companies. Employers often bear the heavy responsibility of fully funding these plans; a task made more challenging by unpredictable market volatility and fluctuating investment returns.
With the $1,000 per month rule, if you plan to withdraw 5% of your savings each year, you'll need at least $240,000 in savings. If you aim to take out $2,000 every month at a withdrawal rate of 5%, you'll need to set aside $480,000. For $3,000, you would aim to save $720,000.
Is $1,500 a month enough to retire on? ›
While $1,500 might not be enough for non-housing retirement expenses for many people, it doesn't mean it's impossible to stick to this or other amounts, such as if you're already retired and don't have the ability to increase your budget.
Can I live on $2000 a month in retirement? ›
“Retiring on $2,000 per month is very possible,” said Gary Knode, president at Safe Harbor Financial. “In my practice, I've seen it work.
What is one advantage of a 401 K over a traditional pension? ›
Advantages. When employees contribute to a 401(k) through a payroll deduction, they have the option to make those contributions on a pre-tax or after-tax (Roth) basis, depending on the employer. If the employee choses pre-tax, their taxable income for the year is reduced, which results in a lower tax liability.
How is a pension better than other types of retirement? ›
Plan Stability
Pensions offer greater stability than 401(k) plans. With your pension, you are guaranteed a fixed monthly payment every month when you retire. Because it's a fixed amount, you'll be able to budget based on steady payments from your pension and Social Security benefits.
What are the two most common retirement plans? ›
The Employee Retirement Income Security Act (ERISA) covers two types of retirement plans: defined benefit plans and defined contribution plans. A defined benefit plan promises a specified monthly benefit at retirement.
Are pensions guaranteed for life? ›
With a lump sum, there is no guarantee the money will last a lifetime. A regular pension payment will last until you die.
Is it good to retire with a pension? ›
The traditional and best approach to achieving retirement security consists of a pension, Social Security, and individual savings. Your pension helps you to maintain your standard of living in retirement, and savings provides important supplemental income for unforeseen expenses.
Should I do pension and 401k? ›
401(k)s and IRAs provide income in retirement, too. But the amount depends on how much you contribute and how well your investments perform over the years. A good retirement strategy is to contribute to a variety of retirement investments, including 401(k)s and IRAs—even if you have a pension.
Do you lose your pension if you quit? ›
Vested benefits refer to the portion of a pension plan that an employee is entitled to receive even if they leave their job before retirement age. In essence, it's the money an employee has earned that is theirs to keep, regardless of their employment status.
