What is the the Difference Between 401(k)s and Pension Plans?
Recently in California, Republican and Democratic senators presented proposals that would allow state workers to choose between CalPERs and other public pension plans and 401(k)s. Those in favor of the proposal believe the state of California will not be able to adequately pay pensions to employees who depend on them if there is another recession. Many pensions are 70% or less funded to pay all pensioners in full. Despite this, the motion to offer a choice was not approved. For now, state workers, teachers, and other work unions and companies will continue to use pensions.
With that in mind, understanding the difference between pensions and 401(k)s is important. Though they both provide money for retirement, they do so in different ways.
What Are 401(k)s?
401(k) accounts are funded almost entirely through an employee’s contributions from pre-tax paychecks over a period of time. The contributions can be placed into stocks, bonds, mutual funds, and other types of investments, depending on the terms agreed upon when the account is established. There is no limit to how much a personal 401(k) can grow, and the growth also occurs tax-free. This allows for rapid growth of some accounts.
However, there is no limit to how much money they can lose, either. If the portfolio performs poorly, or if the investments fail, the account can suffer. One plus of a 401(k) is that they are transferable, so they can be rolled over when an individual changes jobs. 401(k) plans are more popular, and often gain more wealth than pensions but with a higher risk.
The key to success with a 401(k) is establishing the account with a stable, thriving company. From there, it is up to the individual to stay well informed on their investments. Additionally, a factor that can bolster a 401(k) is an employer-matching program. Some employers will match 401(k) contributions for a percentage of every dollar. For example, if an employee makes $100,000 annually pre-tax and contributes 5% to their 401(k), they contribute $5,000 per year. If the employer has a 50% 401(k) matching incentive, the company will add $2,500 to the existing $5,000. This is purely an incentive and comes at no cost to the employee, if offered by the company. Matching programs can drastically improve the rate at which a 401(k) grows.
What Are Pensions?
Pensions are a more traditional route to retirement, and are commonly used by state governments. The two largest public pension programs in the state of California are CalPERS and the California State Teachers Retirement System. Pension programs are provided by a company and are paid into by the employer, employee, or both. The account is controlled by the company and does not offer choices for how the money is invested. Instead, the company offers a monthly payout for retired employees. This payout comes from the investment portfolio that was paid into while they were actively employed.
In general, pensions pose less risk of losing money, but also less opportunity of growth. This poses the question of whether greater risk is worth greater reward. However, pensions do not come entirely without risk. If the company goes bankrupt, the pension does not disappear, but the benefit payout may decrease drastically. Also, pensions are not transferable and are more effective for individuals who work at the same business or state entity long-term.
What Retirement Account Is Right for You?
Though 401(k) accounts are becoming more popular than pensions, they are both viable ways to build retirement income. If you work for a state entity or traditional corporation, you may not have a choice in the matter and will have to pay into a pension. This is why choosing a job with the type of investment incentives that matter to you is important. Also, it iterates the need for diversifying investments and not depending on retirement accounts alone. Planning for retirement can be stressful, but knowing the facts about investments can help in navigating your path to security.