Social Security is intended to replace a modest amount of your annual income. It generally calculates out to about 40% of your average earnings. Of course, for most people, this amount is simply not enough to live on. Especially if you want to retire comfortably!
This means you are going to want to set up other streams of retirement income for when the time comes for you to move on from the working world. While there are a few options, two of the more popular are 401 (k) plans and traditional pension plans.
While each of these options provides funds for retirement they are often administered in very different ways. The general perception is that a pension is better than a 401 (k). However, both are highly regarded as very effective streams of retirement income.
How A Pension Plan Works
A pension is essentially an employer-sponsored fund that is designed to give employees a monthly payment when they reach their retirement. This is provided that they also meet certain eligibility criteria.
To receive pension disbursements, most companies typically require an employee to work a minimum number of years as well as meet certain age requirements. Each individual pension benefit is typically calculated based on the number person’s years of service as well as that person’s earnings.
With a pension, employees don’t typically have to make contributions to the program, the employer funds the pension plan entirely. While this is a nice, it also means that the employees have limited control over how they receive their pension. With some pension plans, the employee has the choice of receiving the pension disbursement in a lump sum. However, monthly payments are more common.
With some pension plans, there is also an option where the employee receives a reduced monthly payment, but the plan includes spouse survivorship. In a pension plan like this the employee can opt to have the pension transferred over to their spouse, should they pass away. Just keep in mind that this option is likely only available upon retirement and most plans will not let you change the option after that point.
In the past pension plans were more common than they are now. The vast majority of pension plans in existence these days are available through government jobs. However, there is a small number of major corporations that offer pension to new employees.
Pension plans are essentially intended to incentivize employee loyalty. The employer is basically promising it as a benefit for employees who put in the long years of service necessary to qualify for it.
In recent years, government-sponsored pensions have had some issues with underfunding, which has seemingly decreased their perceived value. However, pension plans offered by private sector businesses don’t have this problem, which makes them very attractive to a certain segment of potential employees.
How A 401 (k) Works
Private sector businesses have been gradually phasing out pension plans in recent decades in favor of less costly 401 (k) plans which by design shift the primary responsibility of saving for retirement to employees. Contributing to the 401 (k) plan is optional, and different employers may have different rules that govern how much of the employee’s contribution they will match.
Most plans where the employer offers matching funds also come with criteria for how vested an employee is. This means that the longer you work for the employer and contribute to your 401 (k) plan, the more of the employer’s contribution you will be eligible to receive.
Most 401 (k) plans start out with a 0% vestment by the employee. Meaning that if you leave the job a few months after you start, you don’t get to take any of the employer’s contributed money with you in a rollover. As the years go by, the employee’s vested percentage will likely increase until at one point you will be “Fully Vested.”
At that point, if you were to leave the job, you would be able to take 100% of the employer’s contributions in your 401 (k). Different plans and different employers have different rules for how long the vesting process takes as well as how the percentages vary over time.
When it comes to tax purposes, there are two different versions of 401 (k) plans. A traditional 401(k) plan offers a tax deduction when the contributions are made. The vested money the grows in the tax-deferred account and it is only subject to standard income taxes when it is withdrawn. It’s also worth keeping in mind that any money that is withdrawn before age 59 ½ might be subject to an additional 10% penalty. Also, once a retiree reaches the age of 70 ½, they must begin withdrawing minimum distributions or they risk having to pay a penalty equal to 50 percent of the distribution amount.
When it comes to something like a Roth 401(k) plan there is no deduction for contributions, and it can be withdrawn tax-free in retirement. It still carries the 10% penalty fee for early withdrawal. However, that only applies to investment gains, as the contributions have already been taxed. This means there isn’t a penalty for withdrawing a portion of the principal early.
Which Is The Better Option A Pension Plan Or A 401 (k) Program?
For employees, who are interested in working for the same company or organization for a long time, pension plans seem very appealing. After all the employer offering the pension bears all the risk. If financial markets take a major economic downswing the employees, or retirees don’t have to worry about their monthly payments declining.
By contrast, a 401(k) has the employees bear the brunt of the investment risk. Should one or more of the investments fail to perform up to expectations, it can have a major negative impact on a retiree’s nest egg.
There is an additional risk in 401 (k) plans that allow employees to have a significant say in how their money is invested or comes with a portion of a brokerage account. In these situations, the employee may be choosing the wrong or least effective option for meeting their long-term goals.
Let’s say a young employee places money into an aggressive fund when they should be investing more conservatively. Their risk of suffering a major loss that could hamper their compound growth. This is why most 401(k) plan administrators provide educational tools for contributors. Some even offer access to a financial planner who can better guide their election options.
Taken in a certain light the time and energy that goes into effectively managing a 401(k) for maximum benefit might be seen as a drawback. Yet having some control of investments is also seen as a good thing.
Overall transparency is also another difference between a 401 (k) and a pension plan. With a 401(k) plan, it is relatively easy for the employee to see where their money is being invested as well as how it is performing during any given stretch of time. With a pension plan, this information is not always accessible, and some plans even charge a fee for a pension benefit calculation.
This means there is a very real possibility that the employee might not know how much the pension will pay when it comes time to retire. In the case of some government pensions, there might even be underfunding issues!
When you compare the two on paper, a pension plan seems to be the better option. However, they are not as popular or as sound as they once were. At the same time, a wisely administered 401(k) plan can provide significant financial benefits that can potentially exceed the payouts of a pension plan by the time you reach retirement.