Representative Andy Barr (R-Ky.), chairman of the House Financial Services Committee, is introducing a resolution to repeal controversial rules favoring ESG investing.
Employers offer a variety of benefits to attract and retain employees, and helping employees save for retirement is one of the most common perks. There are two main types of retirement plans: 401(k)s and pension plans. Both plans can provide you with a steady income in retirement, but they are very different in some fundamental ways.
Learn more about each type of plan and how they differ.
What is a 401(k)?
A 401(k) plan, also known as a defined contribution plan, allows employees to contribute a portion of their salary (called salary deferral) to an investment account that grows in value. Employers typically match contributions to these accounts. For example, your employer may donate her 50 cents for every dollar you contribute.
401(K) plans have hidden benefits you should know about
Contributing to a 401(k) has several tax benefits. Your contributions are tax deferred. This means you don’t have to pay taxes on the money in your 401(k) until you start taking withdrawals from the account in retirement (at which point your withdrawals are taxed like regular income). This also has the benefit of reducing the amount of income subject to tax. If your 401(k) contributions are enough to move your income into a lower tax bracket, you can keep more of your income.
A 401(k) gives employees the freedom to choose from multiple investment options. (Stefan Vermes/Bloomberg/Getty Images)
You can begin withdrawing money from your 401(k) account starting at age 59 1/2. It is possible to withdraw money from your 401(k) before 59 1/2, but you will be charged a penalty (usually 10%). If you are 73 years old or older, you will need to withdraw money.
Employers typically hire an outside financial services institution to manage investments in employees’ 401(k) accounts. Employees are offered multiple investment options, typically consisting of mutual funds and exchange-traded funds.
Investing your retirement savings can make your money grow significantly, often much more than if your bank savings account simply earned interest. However, it depends on the performance of the stock market. Healthy markets provide financial benefits, but bad markets could cause his 401(k) to lose value.
401(k)s are offered by private companies, or for-profit companies. A similar type of retirement account is offered by nonprofit organizations called 403(b)s. The investment options function much like a 401(k), with some limitations.
What is a pension plan?
In a pension plan, also known as a defined benefit plan, an employer promises a monthly benefit to an employee for the rest of his or her life after the employee retires. The amount of the pension usually depends on the employee’s salary, age, and years of service with the employer.
Both employers and employees typically contribute to a pension plan, but the employer is financially responsible for the pension account.
401(k)s have the potential for significant growth, but their performance is tied to the market. (Angela Weiss/AFP/Getty Images)
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Pension plans, once common, have become increasingly rare. According to the Bureau of Labor Statistics, only 15% of private sector workers have access to defined benefit plans. These are prevalent among state and local government employees, and are accessible to his 86% of such employees. Many companies find sponsoring a pension scheme too financially burdensome and complex to administer.
How are 401(k)s and pension plans different?
With a 401(k), the employee is responsible for investing his or her own retirement funds, while with a pension plan, the employer is responsible for providing the employee with a specified regular amount of money after retirement. Essentially, the key difference comes down to who takes the most risk when funding an employee’s retirement plan.
Employees are responsible for contributing to their 401(k) and receive rewards or losses based on the performance of their investments. This puts the burden of risk on employees, but it also gives them greater control. Employees are free to choose how much to contribute to their 401(k) (as long as it stays within the annual limits). You also have more control over your investment options, from conservative to aggressive. Many 401(k) holders choose aggressive investments at the start of their careers, where they can absorb more risk, and steadily adjust to a more conservative portfolio as they approach retirement.
Pensions provide retirees with a fixed monthly payment for the rest of their lives. (Annette Riedl/Photo Alliance/Getty Images)
In the case of pensions, on the other hand, responsibility and control rest with the employer. Employers decide how much to contribute to the pension scheme. This means there is always a risk that a company’s pension plan will become underfunded. Employees also don’t have much, if any, say in how pension plan funds are invested.
Because pensions pay out for life, no matter how long you live, they can provide greater peace of mind than a 401(k), which can be depleted once the retiree lives long enough. However, that does not mean that pensions are always 100% safe. If your company goes bankrupt, your company pension may disappear along with it.
One famous example is the 2005 bankruptcy of United Airlines. The company defaulted on his $9 billion pension payments, disrupting the lives of 120,000 employees and pensioners. Although the airline had insurance for part of the pension plan, it was not fully insured, leaving employees and pensioners with a huge blow.
conclusion
401(k)s and pension plans each have their own pros and cons. Pensions provide stability. Eligible employees can retire knowing they’ll receive regular checks for the rest of their lives. However, a 401(k) provides employees with additional flexibility, choice, and control.
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Employees are rarely in a position to choose between the two. No matter what kind of retirement plan you are making, it is important to remember that it is only one element of preparing for retirement. You need to be prepared for various events so that the third act of your life will be a wonderful one.
