What is the Difference Between a Pension and a 401K?

About 30 years ago, most employers offered pensions to their employees, but now that 401K funds are more common, it’s good to know the difference between a pension and a 401K. The reason 401K plans are more popular these days is that they’re more beneficial to both employers and employees.

How Pensions and 401K Plans Are Managed

Both pensions and 401K plans are managed through an employer’s bank account, but a 401K plan offers the employee a great deal of flexibility when it comes to accessing and using the funds. A pension can’t be touched until an employee has retired from a company after working there throughout his or her career. Because a pension can’t be transferred from one employer to another, an employee only gets the full amount of the pension payments by staying with the same company for about 30 years. On the other hand, a 401K can be transferred from one employer to another, and unlike a pension, its current value can be seen on the employee’s account Web page. If an employee wants to know how much a pension fund will pay out at a given time, the employer must make some approximate calculations to figure out the employee’s percentage of the fund.

Resource: What is the Pension Protection Act?

It wasn’t until the 1980s that 401K plans were developed by banks as an alternative retirement plan for businesses to offer their employees. Before they were created, employers could only offer pension funds, which were more expensive because they required professional financial management. In most cases, employers could have a say in how the funds were invested, but employees just had to trust their employers and the bank to effectively manage their money. There have been cases of mismanaged pension funds that paid off an inadequate amount after employees contributed money to their retirement for several decades.

How Retirement Plans Pay Off

Although the earnings from retirement funds, including pensions and 401K plans, are tax-free, it would be better to pay taxes on a high-earning investment than to contribute money to a mismanaged pension. With 401K plans, employees get to choose how they want to invest their money. This arrangement offers better employee oversight and earning potential, but it also poses a greater risk.

One big difference between a pension and 401K is that a pension is less likely to lose money than a 401K because pension funds tend to be more conservative investment vehicles. When a 401K loses money, only one employee loses retirement savings, but when a pension fund loses money, all the employees of a company lose money. Because a 401K is assigned to only one employee, when an employer matches employee contributions to the fund, they can greatly increase its value. Most employers contribute to employee pension funds as well, but these contributions are spread out across all the workers of a company.

Another difference between these two retirement plans is that employee contributions to pension funds are mandatory, while 401K contributions can be voluntarily suspended at any time. This flexibility allows 401K-holders to get through hard times more easily or temporarily divert money to another expense.

The offer of tax-free retirement savings is attractive no matter how the money is invested, but some plans have better benefits than others. If you’re considering a job offer, it’s important to know the difference between a pension and a 401K plan.