Pension vs. 401(k): How Are They Different?

For a lot of people, retirement can seem like a far off dream. And it’s a dream that can be realized as long as you’re strategic. That means understanding your options and choosing one that suits your needs.

Pensions and 401(k)s are two solid retirement savings plans that can work well for a lot of people. But they aren’t available to everyone, and they each come with their own pros and cons.

Here’s what you should know to find the best option for you

A traditional pension plan, also called a defined benefit plan, is a retirement plan that can be established by either an employer or an organization, like a union.[1]

“Pension plans are great for providing a guaranteed income source in retirement. The basic agreement with a pension is the company will provide the worker with a predictable lifetime income stream,” says John Shrewsbury, co-owner of GenWealth Financial Advisors. “At the end of the life of a pension participant, the benefit ends.”

Typically, you have to work for an organization for a certain number of years to qualify for a pension (typically five to seven years). The longer you stay, the larger your pension payment will be in retirement — though your salary will also factor into how much you’d get. And your employer would be responsible for the investment side of things so that those contributions can grow and support your guaranteed payment.[2]

Pensions often only require employer contributions.[3] That means you may be able to save for retirement without having to cut into your earnings. Once you’re ready to retire, you’d have to pay income tax on your pension payments. But your employer may also do that for you, so you’d receive a smaller payment once you account for taxes.[4]

A 401(k) is an employer-sponsored retirement plan where the employee makes the primary contributions. However, it often comes with an employer match.[5] That means your employer may match your contributions, up to a specified amount. For example, a 100% match on up to 5% of your salary. You can contribute up to $20,500 per year to a 401(k) as of 2022.[6] Your employer may have an automatic enrollment policy for these, too, which can be especially convenient.[5]

Like a pension, 401(k)s are tax-deferred. And while you’re contributing, you can deduct those funds from your taxable income. But you’d have to pay taxes on your withdrawals in retirement.[5]

As Shrewsbury notes, the burden of investment selection and financial planning is on the employee when you have a 401(k). Since you’re in control, you’d have to choose how to invest your contributions. Your employer may offer a selection of mutual funds and other investment options for you to choose from, often including target-date funds.[7] You’d also have to figure out how you want to withdraw your funds and ensure that you don’t run out of money.

“For those who don’t have investment experience, it can be a problem,” says Shrewsbury. “Often an employee who lacks knowledge about investing in their 401k can be a little like a teenager who has been given keys to the car without any driving lessons. This situation often leads to frustration and worry for the employee, especially when markets are volatile.”

Ultimately it depends on your financial goals.

“Both options have their place in the overall retirement income strategy of a worker. Pensions provide a paycheck for life which can be used, along with social security, to provide a base or ‘floor’ of income that can meet the monthly expenses of their household,” says Shrewsbury. “At the same time, 401(k) plans provide cash for discretionary purposes, the ability to increase your income to offset inflation — a feature that most pensions don’t have — and the ability to leave a legacy asset to family or charity.”

Most likely, however, it will come down to availability. And while 401(k)s are widely available from private companies, you may have a harder time finding an employer who offers a pension plan.[8]

“401k plans have largely replaced pensions because they are far less expensive for companies to operate and fund. They allow a participant to direct his money to investments of his or her choice. This can be quite positive and has been for millions of workers through the years,” he says.