Question

Recent changes in how employees receive retirement, e.g. through a defined contribution plan vs. a defined benefit plan, have caused many to question whether they can retire at the age they expected.

Please address responses to the following questions:

What is the main difference between the 401(k)-type, e.g. defined contribution plans, vs. traditional pension plans, e.g. defined benefit plans?

Which type of retirement plan do you prefer and why?

Answer 1

Pensions and 401(k)s are two types of retirement plans offered by employers.
A pension is an employer-funded retirement account, whereas a 401(k) is mostly funded by employee contributions.
Investments in a pension plan are managed by the employer or plan sponsor; investments in a 401(k) are managed by the individual investor.
One isn't necessarily better than the other, though 401(k)s are now more common than pension plans in the private sector.

Retirement savings is an alphabet soup of options.

There are 401(k)s, 403(b)s, IRAs, SEPs, pensions, and so many more plans available to working Americans saving up to retire one day.

Two of the most well-known retirement plans — pensions and 401(k)s — are totally different, and whether you utilize one or the other, or both, during the course of your career largely depends on where you work.

Pension vs. 401(k): The major differences
Traditional pension plans are defined-benefit plans, while 401(k)s are defined-contribution plans. If you're not well-versed in tax law or financial jargon, that probably doesn't mean much to you, but it's a big distinction.

A pension plan simply means a retirement plan is employer-funded, while a 401(k) is a profit-sharing plan wherein employees, and sometimes employers, contribute to retirement savings.

A pension provides a specific benefit to an employee when they retire, usually determined by a formula that considers the employee's age, years of service, and compensation. At retirement, a 401(k) is worth only employee contributions and investment gains, with the occasional employer contribution.

If you work for a company that offers a pension plan, the company will handle your retirement fund and determine how to invest the money. You might also defer a portion of your paycheck to your pension, but you usually don't have to. If you work for a company that offers a 401(k) plan, the onus to save, invest, and eventually draw an income is on you.

Employers assume the risk with a pension plan and must guarantee retirement income to an employee. Because they're expensive to maintain, many private employers have phased out pension plans and replaced them with 401(k)s or other profit-sharing plans.

There are some pension plans that operate as a hybrid between defined-contribution and defined-benefit plans by combining the simplicity and relative flexibility of the former with the funding mechanism of the latter.

Is a pension better than a 401(k)?
A pension isn't necessarily better than a 401(k). It may seem more advantageous on the surface — hey, you don't have to save any of your own money to retire comfortably — but there are trade-offs.

An employee with a traditional pension plan doesn't get to decide where their future retirement funds get invested today. They also can't take loans or early withdrawals from the plan.

Someone with a 401(k) has full control over their investment choices and can fit them into their overall investment strategy, and has the power to draw on their savings before retirement if needed. If you don't manage risk well and your interest in financial markets is low, you might think a pension plan sounds like a better deal. The opposite could be true, too.

Also, traditional pensions aren't portable. If you leave your job before your pension vests, you'll never see the money. With a 401(k), you get to keep your contributions no matter when you leave.

Can you have both a pension and a 401(k)?
You can have a pension plan and a 401(k) at the same time, but usually not from the same company. If you left a job that offered a pension plan and you worked there long enough to be vested, then the company has a promise to pay you benefits upon retirement.

You won't be able to manage your investments in that pension plan — it's still the duty of your former employer — but you can contribute to 401(k) at your new job, if it's offered.

If someone ask me about my retirement plan then I will choose GIA plan that is GIAs are generally not offered by employers, but individuals can buy these annuities to create their own pensions.

You can trade a big lump sum at retirement and buy an immediate annuity to get a monthly payment for life, but most people aren’t comfortable with this arrangement. More popular are deferred income annuities that are paid into over time.

For example, at age 50, you can begin making premium payments until age 65, if that’s when you plan to retire. “Each time you make a payment, it bumps up your payment for life,” says Littell.

You can buy these on an after-tax basis, in which case you’ll owe tax only on the plan’s earnings. Or you can buy it within an IRA and can get an upfront tax deduction, but the entire annuity would be taxable when you take withdrawals.

Pros: Littell himself invested in a deferred income annuity to create an income stream for life. “It’s very satisfying, it felt really good building a bigger pension over time,” he says.

Cons: If you’re not sure when you’re going to retire or even if you’re going to retire, then it may not make sense. “You’re also locking into a strategy that you can’t get rid of,” he says.

What it means to you: You’ll be getting bond-like returns and you lose the possibility of getting higher returns in the stock market in exchange for the guaranteed income. Since payments are for life you also get more payments (and a better overall return) if you live longer. “People forget that these decisions always involve a trade-off,” Littell says.