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Understanding Pensions and 401(k) Plans: The Basics

A pension and a 401(k) are two different ways that employers help workers save money for retirement. Understanding how each one works is the first step in planning for your financial future.

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A pension is a retirement plan where your employer puts money aside for you while you work. The employer typically manages this money and invests it. When you retire, the company pays you a regular income for the rest of your life. This is called a "defined benefit" plan because the benefit you receive in retirement is set in advance. For example, a pension might pay you $2,000 per month starting at age 65 for as long as you live.

A 401(k) is a different type of retirement savings plan. With a 401(k), you put your own money into the account, usually taken from your paycheck before taxes. Your employer may add money too, called a "match." Unlike a pension, you control how the money is invested by choosing from a list of investment options. The amount you have at retirement depends on how much you saved and how well your investments performed.

According to the U.S. Bureau of Labor Statistics, in 2023, about 15% of private-sector workers had access to traditional pensions. This number has dropped significantly over the past 30 years. In contrast, about 49% of private-sector workers had access to 401(k)-type plans in 2023. This shift means many workers today rely more on their own savings than their employers' guarantees.

• Pensions: Employer manages money; you receive set monthly payments in retirement
• 401(k)s: You contribute money; you manage your own investments; benefits depend on your savings
• Pensions are becoming less common in private companies
• 401(k)s require more individual responsibility and decision-making

Practical Takeaway: Before you can compare these plans, know which one your employer offers. Check your employee handbook or ask your human resources department whether your company provides a pension, a 401(k), both, or neither.

How Pensions Work and What They Provide

Pensions operate on a simple principle: your employer promises to pay you money after you retire. The employer sets aside funds while you work and invests them to grow. When you reach retirement age, you start receiving regular payments.

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Most traditional pensions use a formula to calculate your monthly payment. A common formula is: years of service multiplied by a percentage of your average salary. For example, if you worked 25 years and your average salary in your last five years was $50,000, and the plan uses a 2% multiplier, your calculation would be 25 × 2% × $50,000 = $25,000 per year, or about $2,083 per month.

Pensions offer several advantages. First, they provide income security. You know how much you will receive each month, which helps with budgeting in retirement. Second, the employer bears the investment risk, not you. If the stock market drops, your pension payment does not change. Third, most pensions continue paying until you die, protecting you from outliving your money. Fourth, you do not have to make investment decisions.

However, pensions also have limitations. You must work at the company long enough to "vest," which means earning the right to the pension. Vesting periods typically range from three to seven years. If you leave before vesting, you receive nothing. Additionally, if your company faces financial problems, your pension may be reduced, though federal insurance through the Pension Benefit Guaranty Corporation (PBGC) protects some pensions up to a limit. In 2024, the maximum guaranteed monthly benefit is $5,901 for someone retiring at age 65.

• Pensions use a formula based on years worked and salary
• Employer invests and manages the money
• Payments are predictable and last your entire life
• You must meet vesting requirements to receive benefits
• Federal insurance protects pensions up to a monthly limit
• Pensions are less common in new private-sector jobs

Practical Takeaway: If your employer offers a pension, obtain a statement showing your vesting status and estimated benefit amount. Most companies provide this information to employees annually, sometimes called a "pension benefit statement."

How 401(k) Plans Work and Your Role as Saver

A 401(k) plan puts you in control of your retirement savings. You decide how much to contribute, and you choose how your money is invested. This flexibility comes with both opportunities and responsibilities.

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When you join a 401(k) plan, you select a percentage of your paycheck to contribute. In 2024, you can save up to $23,500 per year in a traditional 401(k), or $30,500 if you are 50 or older. The money goes into your account before taxes are calculated on your paycheck, which reduces your current taxable income. Your employer may match a portion of what you contribute, though this is optional. A common match is 50% of your contribution, up to 6% of your salary. For example, if you earn $50,000 and contribute 6%, your employer might add $1,500 to your account.

You control how your contributions are invested by selecting from options your plan offers, typically including stock funds, bond funds, and money market funds. Some plans offer target-date funds, which automatically adjust from more aggressive to more conservative investments as you approach retirement. Your investment choices directly affect how much money you will have when you retire.

A significant advantage of 401(k)s is portability. If you change jobs, you can move your 401(k) balance to a new employer's plan or to an Individual Retirement Account (IRA). You are not penalized for leaving. Additionally, you receive the full benefit of any employer match, as long as you are vested in the match. Most employer matches vest immediately or within a few years.

The main challenge with 401(k)s is that you bear the investment risk and must make decisions. If your investments perform poorly, your retirement savings will be smaller. You also need discipline to stick with contributions and avoid early withdrawals, which carry a 10% penalty if taken before age 59½, plus income taxes.

• You contribute pre-tax money from your paycheck
• Employer may match a portion of your contributions
• You choose your investment options
• Contribution limits in 2024: $23,500 ($30,500 if age 50+)
• You take on investment risk and decision-making
• You can move your account if you change jobs
• Early withdrawals before 59½ face 10% penalty plus taxes

Practical Takeaway: If your employer offers a 401(k), contribute at least enough to receive the full employer match. This is essentially free money. If your employer matches 50% up to 6%, contribute at least 6% of your salary.

Comparing Pensions and 401(k)s: Key Differences

Deciding between a pension and a 401(k) means understanding how they differ in five major areas: who manages the money, investment risk, income predictability, portability, and control.

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Who manages the money: With a pension, your employer hires professional investment managers to handle all decisions. You do nothing. With a 401(k), you make all investment choices yourself, though your employer selects which investment options are available.

Investment risk: Pensions shift investment risk to your employer. If stock markets fall, your pension payment stays the same. With a 401(k), you bear all investment risk. Poor market performance directly reduces your retirement funds.

Income predictability: Pensions provide certainty. You know exactly how much you will receive each month. A 401(k) is unpredictable. Your monthly income in retirement depends on how much you saved, how well your investments