For many decades, Americans relied on pensions as their main source of retirement money, supplemented by Social Security and private investments, such as bonds. Today, more Americans save for their senior years using retirement plans. During your career, you might be involved with both. Understanding the difference between pension and retirement plans will help you make the best choices to fund your post-work years.
Read More: Advantages & Disadvantages of Pensions
What Is a Pension?
A pension is a retirement contribution made to employees by an employer with a pre-determined, post-retirement payout. The employer pays the full cost of the contribution and manages the pension. Employers manage pensions for decades, taking responsibility for their growth and disbursement to retired employees, who can live for decades.
Employers who offer pensions must follow strict government rules and regulations. Some employers pay insurance premiums to the Pension Benefit Guaranty Corporation to protect workers in the event a pension can’t meet its obligations to covered employees and retirees. Companies often use a combination of in-house staff and an external pension organization to manage their pensions funds.
Today, most pensions are only offered by government agencies, as businesses are saving money by shifting more retirement plan risk and financial burden to employees.
What Are Retirement Plans?
Retirement plans are optional employee benefits that employers offer their employees. The most common is the 401(k) plan, which allows employees to contribute to a tax-deferred retirement plan. Different companies offer different employee “matches,” offering to match an employee’s contribution up to a certain percentage of their annual pay.
For example, when 401(k) plans first came out, many companies offered to match up to 3 percent of an employee’s salary, contributing a dollar-for-dollar match of the pay contributed by the employee. In recent years, employers began offering what they call a 50 percent match. With this plan, the employer will match 50 percent of every dollar you contribute up to 6 percent of your salary. The result is the same 3 percent as with a dollar-for-dollar match.
Why did employers make this switch? They knew that many employees couldn’t afford to contribute 6 percent of their income to their 401(k), so the company would save money paying less in matches. The company got credit, however, for offering the same 3 percent total match.
Some employers offer a 401(k), but no match. In these cases, employees might opt to fund a personal Individual Retirement Account or Roth IRA. In addition to 401(k) plans, employers might offer other tax-advantaged plans, such as a 403(b) for certain types of nonprofit employees.
Read More: Annuity Vs. Pension
Defined-Benefit vs. Defined Contribution
Retirement plans are classified as either defined-contribution or defined-benefit plans. With a defined-contribution plan, the employer and employee decide what to contribute, with employees building different retirement incomes based on their participation. The contribution component is defined in advance, but not the ending retirement income.
With a defined-benefit plan, the employee’s retirement income is pre-determine – hence, the benefit is defined in advance. You know what you’ll be getting each month when you retire, and you can plan your other retirement savings options accordingly. A 401(k) is an example of a defined-contribution plan, while a pension is an example of a defined-benefit plan.
Steve Milano has written more than 1,000 pieces of personal finance and frugal living articles for dozens of websites, including Motley Fool, Zacks, Bankrate, Quickbooks, SmartyCents, Knew Money, Don't Waste Your Money and Credit Card Ideas, as well as his own websites.