If you work for an employer that offers both a 401(k) and a retirement plan, you're in a lucky minority. Participate as much as possible in both plans and expect a comfortable retirement.
Today, only about 15% of private sector employers offer defined benefit pension plans, while 86% of state and government employers do.
Retirement plans have largely been replaced by employer-sponsored retirement savings plans such as the 401(k) and its cousins like the 403(b). This is because they are cheaper for the employer to offer and provide tax benefits to both employers and employees.
In short, if you have access to both, congratulations. If you have a retirement plan but no 401(k), consider investing in an IRA every year.
- A pension provides a fixed monthly retirement benefit for life.
- 401(k)s and IRAs also provide income in retirement. But the amount depends on how much you contribute and how your investments have performed over the years.
- A good retirement strategy is to contribute to various retirement investments, including 401(k)s and IRAs, even if you have a pension.
Traditional pension plans: a return from the past
In human resources department parlance, a retirement plan is known as a “fixed benefit plan” because it guarantees the employee a fixed amount of monthly income for life after retirement, based on the employee's salary. the individual and the number of years worked. A 401(k) is a defined benefit retirement plan that accumulates until the employee retires. At this point, it belongs to the employee and the company no longer has any role to play in its financing or distribution.
Since the late 1970s, when the government first approved tax breaks associated with 401(k) plans, private companies have abandoned fixed-benefit plans and offered a 401(k) plan as a substitute. Self-employed people and others who were not covered by company benefits could open an Individual Retirement Account (IRA) to obtain a similar long-term savings account with similar tax breaks.
How pensions work
Until the 1970s, most workers received a defined benefit pension. They were designed to encourage employees to stay with a company for the long term. The employee was rewarded for his loyalty and the company benefited from a stable and experienced workforce.
As the name suggests, these plans provide a fixed (“set”) payment during retirement for as long as you live. If you prefer a one-time payment, you can opt for a lump sum distribution. You can even choose a combination of both options.
Either way, your benefits are based on things like your age, earnings history, and years of service. Your employer funds the pension and assumes the investment risk.
The company also bears longevity risk. That's the risk that many plan participants will live longer — and collect more money — than the company expects.
Today, defined benefit plans are still quite common in the public sector (i.e. government jobs). But they have largely disappeared from the private sector, where defined contribution plans now reign.
Defined contribution plans
During the 1970s, the government created several defined contribution plans, including 401(k)s and IRAs. They are called defined plans because they are funded by employee contributions, combined with employer contributions if they choose to participate. The amount you will receive in retirement depends on the amount that has been contributed to the plan over the years and the performance of your investments.
Although defined contribution plans were a welcome creation, few realized at the time that they would eventually replace the much-loved traditional pensions that employees had become accustomed to.
Defined contribution plans are cheaper for employers to maintain and fund. They also shift the burden of retirement planning – and longevity risk – onto the employee.
For these reasons, traditional pensions are no longer part of the retirement equation for most private company workers.
Government employees still receive a pension
Defined benefit plans are still accessible to most government employees at the federal, state and municipal levels. While it may be reassuring to assume that your retirement needs will be entirely met by a government pension, it's not a good idea.
Many state and local employee pension plans face substantial deficits to cover future obligations. This means your pension may not be as strong as you once thought. Even government employees should make additional plans to save for retirement.
This is the amount of underfunding of public pensions in 2022, according to recent industry estimates.
Will my pension be enough?
If you have a traditional retirement plan, contact your HR department to find out how much you can expect to retire on. This is usually based primarily on a percentage of your income plus the number of years you have worked for your employer. It also depends on whether you have worked at the company long enough to benefit from the pension plan. Leave before the magic date and your pension rights disappear.
To find out if your pension will be enough to retire comfortably, add your expected pension amount to your expected monthly Social Security benefit. If that's not enough – or if it's barely enough – take a look at defined contribution alternatives, like a 401(k) or IRA, to make up the shortfall.
It's wise to consider alternatives even if it looks like you're ready to retire. You never know what will happen to your pension. And either way, the tax breaks of a 401(k) or IRA are worth the investment.
Watch out for inflation
Inflation is the X factor in retirement planning. Most private employer retirement plans establish a fixed monthly benefit at the start of retirement and pay that amount for the rest of your life.
While this can be very generous in the early years of retirement, you'll start to feel the effects in about ten years when your monthly benefit isn't paying out as much as it used to.
To address this problem, government pensions typically have some type of cost-of-living adjustment (COLA). Still, this COLA might not meet your specific needs.
COLAs are typically based on the Consumer Price Index (CPI), a general survey of changes in prices of essential goods. However, this can work against older people. For example, health care is a major component of a retiree's household budget. Price levels in this sector are rising much faster than in the general economy. If the CPI is 2%, but your personal inflation rate is 5%, you will fall behind even with a COLA provision.
You should have additional savings, such as a 401(k), 457, Roth IRA, or traditional IRA plan, even if you expect a government-sponsored, COLA-adjusted retirement plan.
You don't control your employer's retirement plan
A pension that looks good today may change, especially if it is not part of a collective agreement or other mandate.
Your employer controls a defined benefit plan (subject, of course, to federal law and contractual obligations). This means your company can change its benefit calculation, reduce benefits, or even terminate the plan.
If this is the case, your employer can arrange a payment to workers for their shares of the scheme to date. However, in some cases, funds are left in a poorly managed account that pays meager benefits until the last retired employee dies. In any case, you will not get the expected monthly benefits.
It’s even possible that your company’s retirement plan will fail. There are protections in place to help you preserve some, but not all, of your retirement plan.
Can I have both a 401(k) plan and a defined benefit pension?
Yes, you can have both a retirement plan and a 401(k) plan. These days, relatively few people get both through a single employer. More have one through a current employer and another carry over from a previous job.
In this situation, you can contribute to your 401(k). Your retirement plan benefits are already established.
Can an underfunded pension mean I don't get what I'm owed?
If a pension is not insured with the Pension Benefit Guaranty Corporation (PBGC), it could theoretically fail if a company goes bankrupt because it cannot fund its defined benefit obligations.
Fortunately, most private pensions are insured by the PBGC, providing some protection to eligible retirees even if payouts are reduced in the event of financial catastrophe.
When can I access my 401(k) retirement money?
If these are traditional accounts, you can begin withdrawing from your 401(k) plan without penalties at age 59.5. Before that, you would be subject to a 10% early withdrawal penalty. Regardless of when you make 401(k) withdrawals, you'll also have to pay any deferred income taxes due on the money.
If it's a Roth 401(k) or IRA, you paid the income tax upfront. You can withdraw the money you've contributed (but not the accumulated growth) at any age, and you don't have to withdraw it before a certain age.
How much can I contribute to a 401(k) plan or IRA plan in 2024?
Individuals can contribute up to $23,000 to a 401(k) plan in tax year 2024. The IRA limit for individuals in tax year 2024 is $7,000 .
The future of defined benefit pensions is precarious to say the least. In addition to your pension, it's a good idea to fund a defined contribution retirement plan, such as a 401(k) or 403(b), if your employer offers one. An IRA is another good choice. You can even max out your contributions to both a defined contribution plan and an IRA in the same year.
Other ways to prepare for retirement include building non-retirement investments (stocks, mutual funds, real estate investments), working to get out of debt, and even exploring career opportunities after retirement.
A traditional pension is great if you have one, but never assume your employer will fully cover your pension. Ultimately, the quality of your retirement is your responsibility.