Episode 34: What is the Difference Between a Pension and a 401(k)?

Published: February 4, 2021 | Updated on: February 5, 2021

Thank you for joining us for Episode 34 of our Money Wisdom Question Series, where we answer common financial and retirement investment questions. Today’s question is, “What is the difference between a pension and a 401(k)?”

This is a great question because pensions are starting to go away. Pensions aren’t as popular as they used to be. When my grandfather retired, he got a pension and Social Security. He didn’t have to save any additional money for retirement. Both he and my grandma got Social Security. In addition to this, he got a pension from the food company that we worked at for 40 years. Those things are going away right now. People are much more responsible for saving for their own retirement through a 401(k). So, what’s the difference between a pension and a 401(k)?

Pensions

A pension plan is typically contributed 100% by your company. Let’s say someone works for the State of Massachusetts. They have a pension and the State of Massachusetts is contributing to their pension. None of it is coming out of my paycheck. When someone retires with a pension, their employer has a promise to pay that person. Let’s say it’s $4,000 per month for the rest of someone’s life. The cost is borne by the employer. That’s typically a pension.

A pension is called a defined benefit plan. That means that the benefit that you’re going to get in the future is defined. It promises to pay a certain amount per month at retirement for the rest of someone’s life.

401(k)

A 401(k) is a defined contribution plan, which means you have to contribute to it. The company might do a match, but you have to contribute your own money from your paycheck. You don’t know what that’s going to pay out for the rest of your life because you’re responsible for putting the money into that plan. Yes, your company might match you, but there’s also rate of return based on investments and you don’t know what that will be.

Takeaways

In some cases, you’re much better off with a 401(k) because you can save more money. Also, there are some tax advantages that you get. In many cases, just from a pure financial security and predictability standpoint, pension plans give a lot of peace of mind.

Now you know the difference between a pension plan and a 401(k). With a pension plan, you know exactly what the payouts are going to be at retirement. The company contributes most or all of the money. For a 401(k) you have to contribute your own money. You don’t know what the payout is going to be.

Thanks for joining me and I hope you found this information helpful!

P.S. If you enjoyed this topic and want to learn more, download the article, “What’s the Difference Between a Pension Plan and a 401(k)?

P.P.S. Feel free to submit questions here for a chance to have them answered!