Pension Plans: Definition and How They Differ From 401(k)s

Trader Talk

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.

What is a pension?

A pension is a retirement-savings plan, typically funded by an employer, from which an employee receives regular payments in retirement. Money goes into the pension plan on behalf of the employee during the years the employee works for the organization.

Pensions generally differ from 401(k)s, though both are employer-sponsored retirement plans. And technically Social Security is a pension program, but when people talk about pensions, they tend to mean those with a company.

How do pensions work?

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 pension plans as a perk to attract talent.

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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 own 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 $230,000 for 2020, 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 circumstances, 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.

Is a 401(k) or a pension plan better?

There are upsides and downsides to each, so what’s “better” depends on your circumstances 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) (defined contribution plan)

Pension (defined benefit plan)

How much payout you get

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

Who funds the account

Mostly the employee (an employer may match some contributions)

Mostly the employer

Who manages the investments and bears the investment risk

Mostly the employee

Mostly the employer

Who has control over money before retirement

Employer retains until employee retires

How long a payout lasts

Until the money runs out

What if I don’t have access to a pension plan or a 401(k)?

An IRA is a kind of 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 per year 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.

Here are some of our top picks for the best IRA accounts:

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