What’s The Difference Between Pensions and Retirement?

Pensions are on their way out. Traditional pension plans, also known as defined benefit plans, have become far less common in the private sector. Instead, many employers have shifted to defined contribution plans such as 401(k)s, where the employees contribute to their retirement account, often with employer-matching contributions. According to data from the Bureau of Labor Statistics, only 15% of private industry workers had access to defined benefit pension plans in 2022, compared to 69% of workers having access to defined contribution plans.

Pensions are Defined Benefit Plans

In a defined benefit plan, the employer guarantees you a specific amount of income after retirement. The income you qualify for is based on factors like years of service, salary history, and a predetermined formula. The employer is responsible for managing the investments and assumes the financial risk. 

It's important to note that pensions can vary in their features, eligibility criteria, and payout structures. Some pensions require employees to work for a certain number of years before becoming eligible. Others may have vesting periods during which the employee must stay employed with the company to earn the full benefit. Ultimately, pensions are intended to supplement other sources of retirement income, such as Social Security benefits and personal savings.

Guaranteed income

One of the significant advantages of a defined benefit plan is that it provides a guaranteed income stream during retirement. Retirees receive a fixed monthly payment for the rest of their lives, ensuring a stable income. 

Employer responsibility

In a defined benefit plan, the employer bears the investment risk and manages the plan's investments. This means that employees do not have to worry about making investment decisions or monitoring the performance of their retirement funds. The employer is responsible for ensuring there are sufficient funds to pay the promised benefits. Recently, however, there’s reason to believe that pension funds are being funneled into private equity assets, which could result in the collapse of the value of many Americans’ pension plans.

Inflation protection

Some defined benefit plans provide cost-of-living adjustments (COLAs) to account for inflation. These adjustments help protect retirees from the eroding purchasing power of their benefits over time, ensuring their income keeps pace with rising prices.

Defined Contribution Plans

There are several types of defined contribution plans. Here are some common types of defined contribution plans:

401(k) plans

401(k) plans are one of the most popular types of defined contribution plans. They are typically offered by private-sector employers. Employees contribute a portion of their pre-tax salary. In some cases, employers may also contribute through matching or profit-sharing contributions. The contributions are invested in a range of investment options, such as mutual funds or individual stocks. The funds grow tax-deferred until withdrawal, usually in retirement.

403(b) plans

403(b) plans are similar to 401(k) plans but are offered by certain tax-exempt organizations, such as public schools, universities, and nonprofit organizations. These plans allow employees to contribute a portion of their pre-tax income to individual accounts, often with employer-matching contributions. The contributions are invested in annuities or mutual funds.

457 plans

Retirement plans, or 457 plans, are accessible to employees of state and local governments, along with certain tax-exempt organizations. They allow employees to defer a portion of their salary on a pre-tax basis. The contributions and any earnings grow tax-deferred until withdrawal.

Thrift Savings Plan

The Thrift Savings Plan is a defined contribution plan for federal employees, including military members. It functions similarly to a 401(k) plan, offering pre-tax and potential employer-matching contributions. The plan offers a variety of investment funds to choose from.

Individual Retirement Accounts (IRAs)

IRAs are personal retirement accounts that individuals can contribute to on their own, independent of an employer. There are two primary types of IRAs: traditional IRAs and Roth IRAs. Traditional IRAs allow pre-tax contributions, while Roth IRAs accept after-tax contributions. Both types of IRAs offer tax advantages and a range of investment options.

How Can a Financial Advisor Help With Retirement Planning?

Retirement plans can be complex, with various rules, contribution limits, tax implications, and investment options. A financial advisor can explain the different types of retirement plans available to you, such as defined benefit plans, 401(k)s, IRAs, or other options. They will educate you about each plan’s features, benefits, and potential drawbacks to help you make an informed decision.

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