In many experts' eyes, America is facing a retirement crisis. Very few people have pensions to look forward to these days, many with 401(k)s are not taking full advantage of them, and many workers, such as the self-employed, are not offered either retirement vehicle.
Here's a close look at the difference between a pension and a 401(k) plan -- often referred to, respectively, as a defined benefit (DB) plan and a defined contribution (DC) plan -- examining their risks, investment options, tax treatment, vesting, and more. You'll find some valuable tips for making the most of your retirement plan, too.
What's a pension?
A pension is a retirement plan offered to workers by an employer, promising them a certain sum or income in the future. It's referred to as a defined benefit plan because the future financial benefits (the regular income or a lump sum) are defined.
Typically, pensions mainly are funded by the employer, sometimes with workers making contributions, too. The benefit typically is determined by a formula that uses inputs such as length of service and salary, and the worker knows how much money to expect. Such relative certainty can make planning for retirement relatively low stress.
Pensions have been around for quite a while, starting with public-sector jobs, and today it's mainly public-sector jobs that still offer pensions (more on this soon). The New York City Teachers Retirement Plan was the first public-sector pension, created in 1869. The Civil Service Retirement System was created by the federal government in 1920.
In the old days, most companies were small and family-owned, so pensions didn't make as much sense. As American companies grew larger over time, though, they were more able to offer pensions. In 1875, American Express created the first private pension plan. By 1930, hundreds of companies had set up pension plans. These included U.S. Steel, General Electric, Goodyear Tire and Rubber, and AT&T precursor American Telephone and Telegraph.
The Revenue Act of 1928 helped spur the spread of pensions, permitting companies to take tax deductions for sums they contributed to qualified trusts such as those set up to cover future pension obligations. Companies found pensions useful as a benefit to offer employees as they would attract and retain workers, resulting in lower turnover.
The Employee Benefit Research Institute (EBRI) has tracked the growth -- and eventual shrinkage -- of pensions, noting that there were 4.1 million private-sector workers covered by a pension in 1940 -- that's 15% of them. The figure rose to 35.9 million workers, or 46% of the private-sector force, by 1980, before starting to fall. The percentage of private-sector workers with pensions dropped to just 18% in 2011 and 13% more recently. Why? Well, it's largely due to the growth of 401(k) plans.
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What's a 401(k)?
While a pension is a defined benefit retirement plan, a 401(k) is a defined contribution retirement plan. Its certainty lies in what goes into the account -- such as when you contribute 5% or 10% of your salary each pay period -- with the ultimate financial benefit you'll receive being relatively uncertain.
A 401(k) account -- and its sister account, the 403(b), offered by many non-profit workplaces such as public schools and state and local governments -- is mainly funded by contributions from a worker, often with some matching funds chipped in by the employer. (You'll recall that pensions are funded by employers.) A common matching plan is when an employer contributes 50% of what you contribute to your account up to 6% of your salary. So if you earn $80,000 and contribute 6%, or $4,800, your employer will match 50% of that, adding $2,400 to your account.
401(k) plans entered the scene about 40 years ago, named for a section of the Revenue Act of 1978 in which they were introduced. In 1981, contributions were allowed to be taken via payroll deductions. In the first few years of 401(k) availability, only a few major corporations, such as Johnson &Johnson, PepsiCo, and Honeywell, offered their workers 401(k) plans.
Plans proliferated quickly, though, with almost half of large employers offering them by 1982. More than 30 million workers were participating in plans by 1996, with total assets topping $1 trillion. In 1996, the Pension Protection Act permitted the automatic enrollment of workers into 401(k) plans, with target-date funds allowed as a default investment option. Today, more than 50 million workers participate in 401(k) plans, and there were more than 500,000 plans in existence as of 2015.
Total assets in 401(k) plans topped $5.2 trillion at the end of 2017. That's a lot of money, but what does the typical 401(k) account contain? Well, Fidelity Investments, which manages many workplace 401(k)s, reported an average 401(k) balance of $102,900 at the end of the first quarter of 2018. The average 403(b) account held $82,100.
Many who have made good use of 401(k) accounts have done quite well. Fidelity recently reported that 401(k) account holders with balances of $1 million or more number more than 150,000 -- up 45% over year-earlier numbers. It's worth noting that most of those folks have been saving for roughly 30 years.
Pension risks vs. 401(k) risks
As you might have noticed by now, the shift from pensions to 401(k)s has involved a shift in risk, too, from employer to employee. With pensions, the employer promises its workers that defined benefit and is on the hook to plan for and fund it. Thus, the employer will typically set up a special pension fund and invest the money in a way designed to meet eventual needs. (This hasn't always gone so well, though -- more on that soon.)
Meanwhile, with a 401(k) account, just about all the risk is borne by the employee, who contributes money to the account -- often with some employer matching funds chipped in -- and controls how much money is contributed. That's the defined contribution. But how rapidly the invested money grows is far from certain. It depends on how the money is invested and often on how well the stock and/or bond market fare over the investment period.
A worker might diligently contribute $10,000 per year for 15 years to their 401(k), and if the money grows at an average annual rate of 8%, it could reach $293,000. But if most or all of the money is in the stock market and in the year before the employee retires, the market sinks by 20%, their account balance could fall by almost $60,000, to $234,000. There are ways to manage this risk a bit, of course, such as by not having as much in stocks as you approach retirement or by delaying retiring a bit if need be (and if possible) if the market tanks, but such measures wouldn't have been necessary with a pension.
Pension investment options vs. 401(k) investment options
Another key difference between pensions and 401(k) accounts is how the money in them is invested. Corporate pension funds have traditionally favored low-risk investments because it could be catastrophic if they were to suffer a major loss and be unable to meet their obligations to retired workers. Thus, government bonds, highly rated corporate bonds, and perhaps some blue chip stocks and preferred stocks were the norm for a long time. (Indeed, funds were regulated and limited to low-risk investments.)
The rules have changed over time, and now pension money can be invested more broadly, which has allowed pension fund managers to seek higher growth rates. Many of them invest a lot of money in the private equity world, such as in hedge funds. They also may invest in real estate through real estate investment trusts (REITs) and even be in junk bonds, commodities, and derivatives. Many invest in well-regarded index funds, too.
You may notice that in the scenario above, the employee has little control over how pension fund money is invested. The opposite is true when it comes to 401(k)s. With a 401(k) plan, a worker typically has a menu of investment options to choose from, such as a dozen or so funds, some of which may be index funds and/or target-date funds that invest in stocks and bonds and shift their allocation over time as the projected date of retirement gets closer.
That control can be seen as a good thing, but it's also not such a good thing -- especially when the employee isn't too investment-savvy and doesn't know what's best. Sure, investments rated as extra safe may be appealing, but they typically will grow very slowly, while enticing stock fund offerings (such as, perhaps, an emerging markets fund) may end up being very volatile and sometimes not perform as expected.
Expected income from pensions and 401(k)s
How much might you expect to receive from a pension or a 401(k) account? Well, amounts will vary greatly. A common rule of thumb, though, is that pensioners receive 1% of the average salary they received in their last five years of work for each year that they worked at their company. So if you earned an average annual income of $100,000, 1% would be $1,000. If you worked at your company for 27 years, you'd get 27 times $1,000, or $27,000 per year.
It's not typical for private-sector plans to adjust payments for inflation, but union pensions often do. They also tend to base payments on total years of union membership, even if the membership spanned more than one employer. Union-negotiated pensions also tend to be more generous, often paying more than 1% of average salary.
With 401(k) plans, what you get out of them will largely be determined by how much you put into them. There are annual contribution limits that will restrict the most generous funders. For 2018, the contribution limit for 401(k)s and 403(b)s) is $18,500 -- plus an additional $6,000 "catch-up" contribution for those aged 50 and older. So if you're, say, 53, you can contribute up to $24,500 to your 401(k) this year.
The following table shows how various regular contributions can grow over time -- at an annual average rate of 8%:
Growing at 8% for
$10,000 Invested Annually
$15,000 Invested Annually
$20,000 Invested Annually
Calculations by author.
Whatever sum you have by the time you retire is the amount that will generate your retirement income. If you use the flawed-but-still-useful 4% rule, it suggests withdrawing 4% of your nest egg in your first year of retirement and adjusting future withdrawals for inflation. Thus, if you accumulated the $741,344 above over 20 years, you could take out $29,654 in your first year.
Pension tax treatment vs. 401(k) tax treatment
The IRS grants favorable tax treatments to lots of different retirement plans. With pensions, an entity contributing to a qualifying pension fund is allowed a tax deduction for that -- and that entity is typically an employer. Pension income received by the retiree is generally considered taxable income, subject to income tax rates. Workers should receive a 1099 form at year-end detailing the taxable income they received from the pension during the year. (Some pensions, such as military or disability ones, may feature tax-free income.)
With 401(k)s, employees can enjoy significant tax breaks, whether upfront via a traditional 401(k) or at the time of withdrawal via Roth 401(k)s. With a traditional 401(k) account, just as with a traditional IRA, you contribute pre-tax money, reducing your taxable income for the year, and thereby reducing your taxes, too. (Taxable income of $70,000 and a $5,000 contribution? Your taxable income shrinks to $65,000 for the year, letting you avoid paying taxes on that $5,000.)
The money grows in your account and is taxed later at your ordinary income tax rate when you withdraw it in retirement. Many of us will be in lower tax brackets by then, so not only is the tax bill postponed, but it's often reduced.
A Roth 401(k), on the other hand, has the potential to be much more powerful. You contribute post-tax money to a Roth 401(k), so your taxable income isn't reduced at all in the contribution year. (Taxable income of $70,000 and a $5,000 contribution? Your taxable income remains $70,000 for the year.) Here's why the Roth 401(k)is a big deal, though: If you follow the rules, your money grows in the account until you withdraw it in retirement -- when it's yours tax-free.
Pension vesting vs. 401(k) vesting
Pensions often feature vesting schedules, meaning that a worker isn't fully entitled to funds from the pension until they have worked for the company for a certain number of years -- often no more than seven. Some schedules dictate that the worker will get no pension benefits at all if they leave the company before the end of the vesting period -- which might be five years, as an example.
Many other schedules will be graduated, qualifying workers for, say, 20% of their benefit after their first year with the company and another 20% for each successive year, until they've toiled there for five years and are considered "fully vested." Some companies offer pension plans that vest immediately, meaning workers don't have to wait at all.
Note that any employee contributions to a pension plan are not subject to any vesting restrictions. That's their money and it remains their money, accessible to them via the pension.
With 401(k) plans, meanwhile, employee contributions are similarly immediately available, but any employer matching contributions made may only be available to workers in accordance with a vesting schedule. Some companies will not impose a vesting schedule, while others may do so -- with it generally taking from three to seven years for the employee to become fully vested. Per a recent Vanguard report, 45% of 401(k) plans studied had matching funds vest immediately, which is optimal. But about 30% of plans had a five- or six-year schedule.
Pension liquidity vs. 401(k) liquidity
Liquidity in financial terms refers to cash and the availability of cash. If investments are tied up in an investment such as a long-term certificate of deposit (CD) or bond, they may not be very liquid. With pensions, remember that companies have pension funds that they contribute money to that will fund disbursements to retired workers. If there isn't enough money in the fund to cover obligations, the pension will be suffering from a liquidity problem.
With 401(k)s, liquidity is far less likely to be an issue. Contributions are made over time and typically managed by a plan administrator such as Fidelity Investments or Vanguard. The money that workers contribute (along with any company matching funds) is there, available for withdrawal according to the rules. Or it can be rolled over to an IRA when the worker changes jobs or cashed out early or borrowed from. (Those last two options are inadvisable and can result in penalties and/or taxes.)
As hinted at above, many pension funds have run into trouble in recent years due to being underfunded. Public pension funds, for example, got hit by the recession and haven't fully recovered yet. State and local pension funds went from being 92% and 97%, respectively fully funded in 2007 to just 68% and 72%, respectively, by 2016, per a Reuters report. It's true that the stock market has been surging in recent years, but remember that pension funds aren't typically invested all in stocks.
Some private companies are faring better. For 2018, the 100 public companies with the largest pension funds averaged an 86% funding rate, per research by the folks at Milliman. That's up significantly from the 81% rate at the end of 2016. As of 2017, General Electric had the largest pension fund shortfall, of $31 billion, per a Bloomberg.com report, and was 67% funded. Some companies had much lower funding ratios:
Ratio of Pension Assets to Pension Obligations, 2017
Delta Air Lines
Procter & Gamble
These bad numbers can improve, and rising interest rates with higher-yielding bonds can help. Even if a company isn't able to fulfill its obligations, there's the Pension Benefit Guaranty Corporation (PBGC), which insures vested pension payments (for many but not all pension plans) up to a certain sum annually for pensioners aged 65 and up.
That's reassuring, but here's an ironic twist: The PBGC itself is underfunded. In its latest annual report, it warned that there's only a 1% chance that its multi-employer insurance program that covers millions of union workers in industries such as transportation, mining, construction. and hospitality will remain in the black after 2026. Its single-employer program, which covers even more people -- some 38 million -- has been strengthening, though. Congress has been looking into how to address the union pension problem -- and PBGC director Tom Reeder has warned that if no action is taken, some union retirees could see their pension benefits drop by 90%.
Part of the problem with many underfunded pension plans is that companies often have been overly rosy in their investment growth projections. After all, it's easier to project that your fund will soon be fully funded if you expect a high rate of return on your investments. Also, especially with some union pension plans, there are fewer workers today generating funds for the pension accounts and more retired workers making demands on them.
Meanwhile, 401(k) plans have problems of their own. For starters, since most of the responsibility for using them to save for retirement lies with the workers, it has resulted in many millions of workers not using them -- either because they're not financially savvy enough to understand their benefits or because it's too hard to sock away meaningful amounts. Worse, many employers just don't offer the plans. A report by the Pew Charitable Trust found that 35% of workers in the private sector don't have plans available to them.
A Harvard Business Review article summarized some problems with 401(k)s, noting that, "Among Americans between 40 and 45 years of age, for example, the median retirement account balance is just $14,500 -- less than 4% of what the median-income worker will require in savings to meet his retirement needs." Additionally, "Even when contributions are made, 401(k)s tend to earn subpar returns on average due to limited investment strategies and high administrative expenses," according to a Harvard Business Review report.
Make the most of your pension
There isn't too much under your control when it comes to a pension because the formula your company uses will dictate how much you'll receive. You usually can make the sum a little greater by working for more years or by attaining jobs with higher salaries.
Other than that, the next way to influence how much you'll get from your pension is if you get to choose between a lump-sum payout or many payments over time. Lump sums can be enticing, as they'll probably seem like such a large amount. But if you take a lump sum and then invest it poorly or spend it too quickly, it will be gone, along with the degree of financial security it offered. Opting for monthly payments can keep you afloat longer, even if you live a very long time.
The lump sum can make sense in some situations, though, such as if you don't expect to live for many more years, you have no spouse who would be depending on monthly income, and/or you have sufficient other funds to carry you through retirement.
Make the most of your 401(k)
There are lots of ways to make poor use or good use of a 401(k) plan. Here are some tips:
Participate! A 401(k) will offer no help for your retirement if you don't use it or if you underuse it.
Grab all available company matching dollars: Contribute enough to your account to grab any available matching funds from your employer -- it's free money.
Don't overload your account with your employer's stock: Yes, you probably know your employer better than any other company, but even the best companies can fall on prolonged hard times -- or can fail. And your employer already provides much, if not most, of your financial support. If you're depending on your employer for your income, as well as relying on it for your retirement, you've got a lot of eggs in that one basket. Try not to keep too much of your net worth in company stock -- perhaps not more than 10%, at most.
Don't cash out your 401(k): Cashing out deprives your retirement nest egg of valuable dollars. Even if your 401(k) only has $20,000 in it, if it can keep growing for another 25 years, it would amount to about $137,000 retirement dollars (assuming an 8% average annual growth rate). Instead of cashing out, consider rolling over the funds in your 401(k) into an IRA, where fees might be lower and investment options broader. Another choice many have when closing out a 401(k) account is to convert that money into an annuity that will pay regular sums monthly in retirement. Just be sure it's a fixed annuity and not a variable or indexed one, as those are more problematic.
Don't borrow from your account: Don't borrow from a 401(k) plan, either, unless it's an emergency and you really have no better option. Borrowing means removing dollars that could be working and growing for you -- and that may never be repaid if you run into more trouble. (Not repaying a 401(k) loan can result in penalties and taxes, too.)
Be smart about beneficiaries: Be sure to designate one or more beneficiaries. Fail to do so, and the money may go to a party specified by a state formula and not to whom you want. Also, designate your account as POD or TOD -- payable or transferable on death -- and it will get to your beneficiaries more swiftly, generally avoiding probate. Review and update your beneficiaries, too, as your wishes and situation may change over the years.
Whether you have a pension coming to you or are saving money for your retirement in a 401(k), you can do well in your golden years. Just stay on top of your saving progress -- and be sure to have a retirement plan.