Choosing Between a Pension or a 401(k) Plan

Individuals must assume all the risks of 401(k) investing.

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When you start a new job you will need to decide whether you want to be involved in a retirement plan. You might have a couple of options available to you, perhaps including a traditional pension plan (a defined-benefit plan) or a defined-contribution plan, such as a 401(k).

A pension. A defined-benefit plan will typically pay you a set amount each month in retirement. The calculation for how much you receive depends on how long you are with the company, as well as what salary you end up with.

With a defined-benefit plan, contributions are made, and you are promised a certain outcome. The employer can make contributions to the plan without your help, or you can boost your retirement benefit by making your own contributions.

The main point of the defined-benefit plan is that you receive a reliable income source when you retire. The investment risk that might come as a result of the plan is borne by the employer or by the government.

At first glance, it seems as though the defined-benefit plan is most beneficial to the worker, since the income is assured and someone else takes on the investment risk. However, there are some cases when defined-benefit plans have been reduced. In cases of bankruptcy or other problems, such a plan might be reduced, and suddenly what you thought was a sure thing pays out less than it used to.

A 401(k). With a 401(k) plan, instead of someone else taking on the risks associated with an investment not doing well, you are responsible for the risk. A defined-contribution plan means that you and possibly your employer make contributions to your retirement plan, and the benefit is entirely dependent on how much you put in, and how the market performs.

Most workers are fairly acquainted with defined-contribution plans, since these are the most common types of retirement plans offered by employers these days. Your retirement benefit depends on how much you put in, how long you contribute, and how well the investments do over time.

The main drawback to defined-contribution plans is that you are at the mercy of the markets. If you have the ability to choose the investments you hold in your account, a little careful planning can help you offset some of your investment risk. But if your employer doesn’t offer good choices and you are forced to use high-fee funds it can erode some of your returns.

If you aren’t happy with your defined-contribution plan, it is possible for you to open an IRA. However, the amount you can contribute to an IRA is much lower than what you can contribute to a 401(k). You might want to consider a rollover from your 401(k) to your IRA if you are unhappy with the way your company’s defined-contribution plan is run.

Picking a plan. In light of recent concerns about the markets, as well as worries about how much people contribute to retirement accounts, many people would like to see a return of defined-benefit plans. However, you are unlikely to have that option when you start working with most employers, especially in the private sector. Pensions are few and far between these days.

You are more likely to have access to a defined-contribution plan, which means that you have a greater responsibility to make choices about where to invest your money. Make sure you understand this fact, and take steps to research investments that are likely to reduce some of your exposure to investment risk, such as calculating your retirement number and looking at creative retirement options.

FMF writes at Free Money Finance, a personal finance site that helps readers grow their net worth. He shares practical tips that have helped him accumulate a significant net worth and can do the same for others.