What's the difference between a pension and a 401K?
Question: What is the difference between a pension and a 401K plan? I know they both have to do with retirement, but are they the same thing?
Answer: They are not.
In some ways, retirement planning is like a math problem. In reality, it is much more than a math problem, but there are similarities.
Let’s start out with math that even I can understand: 2 + 2 = 4.
If the numbers of the left hand side are the inputs, then knowing simple math will give you the output. In that case, you can define the inputs (2 + 2) and know what the output will be.
Furthermore, if the numbers on the right hand side are outputs, then knowing simple math will allow you to pick any number of input numbers that will work. You can choose “2 + 2” or “3 + 1” or even “4 + 0.” Any of these combinations will work if you are trying to reach a pre-determined answer.
The difference between solving a math problem for the output or solving it for the input, is at the core of the difference between a pension plan and a 401K plan.
A pension plan is one where the outcome has been “defined.” So pension plans are often referred to as “defined benefit” plans.
Suppose I go to work for the XYZ Company and one of the stipulations of my employment is a promise XYZ makes to me that for every year I work there, they will pay me 2% of my final salary. So if I work there for 30 years, I can count on getting 30 x 2%—or 60%—of my final salary in retirement.
So maybe I started at XYZ making minimum wage in the mail room. But I worked my way up the ladder over the years, and retired as Head Pencil Pusher making $100,000 per year. According to the pension formula, XYZ has promised to pay me $60,000 per year for the rest of my life.
If you haven’t figured it out yet, THAT is a pretty good deal.
And you may have also guessed that making those kinds of open-ended, defined benefit “pension promises” leaves the company vulnerable to some pretty high expenses for providing that benefit.
So, it should be no big surprise to learn that a generation ago, companies began adopting a different approach.
Instead of making a promise of a certain benefit in the future, companies began shifting the burden of retirement planning (and the cost!) to the other side of the table, to their employees.
Instead of defining what the future benefit would be, companies began simply defining what amount (if any!) they would contribute towards the retirement efforts of its employees. These plans became known as “defined contribution” plans, for obvious reasons. The most popular of these plans is taken from section 401(k) of the Internal Revenue Code, and they are known unimaginatively as 401K plans.
In the typical 401K plan offered these days, employees are able to make pre-tax contributions of their own money into the plan, with the hope that those funds will grow over time. Funds in your 401K account may be invested in ultra-safe bank account type options, or they may be invested more aggressively utilizing mutual funds that invest in stocks, bonds and real estate.
So, how much can you expect to have in your 401K plan when you retire? Hmmm…that’s kind of the problem now, isn’t it? There’s really no way to know.
The math problem is now more complicated than just “2 + 2.” It’s more like “dollars you put in the plan each year” x “number of years you do this” x “whatever rate of return you earn on those funds over the years.” Yipes…how can you know how much you’ll have?
Well, you can’t. So you’ll just have to make an educated guess, hopefully with the help of someone educated in guessing about these sorts of things.
And here is one instance where optimism is not a virtue. I’d rather be slightly pessimistic about the returns I can expect in my 401K account. After all, the list of people who have come to me complaining that they have too much money in their 401K account at retirement is really, really short.
Most employees these days will be offered some kind of defined contribution, 401K style retirement plan…if they are offered anything at all. Your best bet is to sock away as much as you can as early as you can.
But if you do have a pension plan through your employment, consider yourself very fortunate. Those kinds of retirement arrangements are becoming as rare as a bald man headed into a barber shop.
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