Pension vs 401(k)

The reliable pension plan was once a staple retirement benefit in corporate America.  

What is a pension?

American Express offered the first private sector pension plan in the U.S. way back in 1875, and popularity of this benefit peaked sometime in the 1970s when nearly 50 percent of private sector employees in the U.S. had access to a pension. In 2019, only 16 percent of private industry workers had access to such a benefit, according to the Bureau of Labor Statistics.

Pensions, or defined benefit plans, are valued for their steady income and baked-in guarantees. In short, an employer agrees to pay its workers a steady income — based on total years of service — for the rest of their lives in retirement. In that way, employees are rewarded for sticking with the company for the long-term. Today, only 16 percent of private industry workers have access to such a benefit.

What is a 401(k)?

A 401(k) is a retirement savings plan sponsored by an employer. It lets employees save and invest for their own retirement on a tax-deferred basis. Employees can contribute to their 401(k) with pretax dollars, which reduces their taxable income for the year. The money in the account can grow tax-deferred, meaning you won’t pay taxes on it until you withdraw it in retirement. Some employers offer 401(k) match up to a certain percentage.

But are pensions better than a 401(k)? Is salt better than pepper? Or left better than right? It's hard to say which is better because they’re just different. Instead, it makes more sense to focus on their unique attributes and the role they can serve in a financial plan. A pension and 401(k) are both financial tools, but neither is an entire retirement plan.

Is a 401(k) better than a pension?

Pensions are a pretty hands-off, straightforward benefit. After putting in so many years of service, you’re rewarded with a pension in retirement. The company cuts you a monthly check for the rest of your life, or you can take a lump-sum payment upon retirement. Some programs even allow your spouse to continue receiving money after your death. And, unlike a 401(k), you don’t make contributions or manage a pension in any way.

A pension provides level, steady income that you can depend on. In fact, many pensions are insured by the government (up to a certain amount), which means you’re protected if the company goes under or is acquired by someone else.

A 401(k) is technically considered a defined contribution plan, and, unlike a pension, it’s funded using pre-tax dollars from your income rather than by your employer. Often, however, your employer will match a defined percentage of your contributions.

A 401(k) allows you to tap into the potential of markets and enjoy tax-advantaged growth while funds are held the account. This allows you to benefit from being invested in the stock market, which has historically returned 7 percent annually after accounting for inflation. But markets don’t always go up, which means your retirement savings may be exposed to risk, and there’s no lifetime income guarantees.

Pensions offer guaranteed income while 401(k)s typically offer variable income

The big difference between a pension and 401(k) that’s invested in the stock market is that the former provides a guaranteed income stream, while the latter is a variable income stream. In retirement it’s good to have a mix of both to help manage different risks.

Variable income streams are likely exposed to markets, which increases risk but allows you to potentially capture upside and collect dividends to temper inflation risks. Guaranteed income streams, like a pension, are steady and will last a lifetime. Guaranteed income reduces exposure to market volatility and longevity risk (outliving your savings in retirement) in a financial plan.

How to guarantee retirement income without a pension

Although pensions are in decline, there are still several ways to add guaranteed income to your retirement plan. For starters, you can begin receiving Social Security benefits as early as 62 (the benefit grows the longer you wait). Social Security will pay you for life, but it probably won’t cover all your needs in retirement. But you have options.

An annuity, which can provide guaranteed, lifetime income, is another product that’s a good substitute for a pension. There are several types you can choose from, tailored for your life stage. Lastly, the cash value of permanent life insurance can also serve as a source of safe income.  

People may bemoan the decline of the pension, but that doesn’t mean a 401(k) is an inferior substitute for long-term financial health. Today, there are many financial options that can replicate the steady, reliable attributes of a pension.