A pension and retirement savings are not the same thing

A pension is a monthly payment your former employer sends you for life, based on how long you worked there and what you earned. A retirement account — like a 401(k) or IRA — is money you and your employer set aside during your working years, which you then withdraw from after you stop working. The key difference: a pension pays you automatically every month whether you live to 90 or 100. A retirement account is a pot of money that can run out if you withdraw too much or live longer than expected.

Many people have one, the other, or both. Some have a pension from an old job and a 401(k) from a newer one. Others have only a 401(k) because pensions have become rare in private industry. Understanding which you have — and how each one works — changes how you plan to pay your bills in retirement.

Key Takeaways

  • A pension is a may provide monthly payment from your employer that lasts your entire life; a retirement account is a balance you control and can deplete.
  • Pensions are mostly found in government jobs and some union positions; private employers rarely offer them anymore.
  • With a pension, your employer takes the investment risk; with a 401(k) or IRA, you do.
  • You can have both a pension and retirement savings, and many people do.
  • The way you receive a pension payment — lump sum or monthly — affects how long the money lasts.

How a pension works

A pension is funded by your employer (and sometimes by you through payroll deductions). The employer hires an investment manager to grow that money over time. When you retire, you receive a monthly check for the rest of your life. The amount is usually based on a formula: your years of service multiplied by a percentage of your final salary. A common formula is 1.5% per year of service — so 30 years of work at a final salary of $60,000 would give you roughly $27,000 per year ($60,000 × 30 × 1.5%).

The employer bears the risk that the pension fund will have enough money to pay you. If the fund loses money in the stock market, the employer has to make up the difference. If you live to 105, the employer keeps paying. This is why pensions have become expensive for employers and why most private companies stopped offering them decades ago.

When you leave a job with a pension, you typically cannot take the money with you immediately. You must wait until you reach the pension's retirement age (often 55 to 67, depending on the plan) to start receiving payments. Some pensions let you take a lump sum instead of monthly payments, though this is less common and usually requires you to make the choice before you start receiving money.

How retirement accounts work

A 401(k), 403(b), or IRA is a personal account in your name. You contribute money from your paycheck (or from your own pocket, in the case of an IRA), and your employer may add matching contributions. The money sits in investments you choose — usually mutual funds or target-date funds — and grows over time. You own the account and control how much you withdraw each month.

You take on the investment risk. If the stock market drops the year before you retire, your account balance drops with it. If you withdraw too much early, you may run out of money. If you live longer than expected, you have to make your savings last. This flexibility is both an advantage (you control the money) and a burden (you have to make the right decisions).

You can withdraw money from most retirement accounts starting at age 59½ without penalty. Some accounts require you to take a minimum withdrawal each year after age 73 (this is called a required minimum distribution, or RMD). If you withdraw before 59½, you usually pay a 10% penalty plus income tax on the amount withdrawn.

Who gets pensions today

Pensions are now mostly limited to government employees (federal, state, and local), teachers, police officers, firefighters, and some union workers. Private companies rarely offer pensions anymore. If you work in the private sector and your employer offers a retirement plan, it is almost certainly a 401(k) or similar account, not a pension.

If you worked for a government agency or union job at any point in your career, you may have a pension waiting for you. Many people forget about old pensions from jobs they left years ago. If you are unsure whether you have a pension, contact your former employer's human resources or pension office, or search the National Registry of Unclaimed Retirement Benefits at unclaimed.org.

Pension versus 401(k): who bears the risk

The biggest practical difference between a pension and a retirement account is who bears the risk of living too long or investing poorly. With a pension, your employer bears that risk. They promised you a monthly check for life, and they have to deliver it no matter what happens in the stock market or how long you live. This is why pensions are called "defined benefit" plans — the benefit (your monthly payment) is defined and may provide.

With a 401(k) or IRA, you bear the risk. You have to decide how much to invest, where to invest it, and how much to withdraw in retirement. If you invest too conservatively, inflation may erode your purchasing power. If you invest too aggressively, a market downturn near retirement could reduce your balance significantly. If you withdraw too much too soon, you may run out of money. This is why these accounts are called "defined contribution" plans — the contribution is defined (you and your employer put in a set amount), but the benefit is not.

What happens if you have both

Many people have a pension from an earlier job and a 401(k) from their current job. This is common for people who worked in government or a union early in their career and then moved to private industry. Having both can be an advantage: the pension provides a may provide base income, and the 401(k) provides additional savings you control.

If you have both, plan for them separately. Calculate what your pension will pay you each month, then figure out how much additional income you need from your 401(k) or other savings. Some people find that their pension alone covers their basic expenses, and their 401(k) is available for travel, hobbies, or emergencies. Others use their 401(k) to supplement a smaller pension.

Lump sum versus monthly payments

Some pensions give you a choice: take a monthly payment for life, or take a lump sum all at once. This is a major decision that you usually cannot undo. A lump sum is tempting because you get a large amount of money and can do what you want with it. But if you invest poorly or withdraw too much, the money can run out. A monthly payment is smaller but may provide for life, which protects you if you live a long time or if markets perform poorly.

The lump sum amount is calculated using assumptions about how long you will live and what interest rates will be. If you think you will live longer than average, a monthly payment is usually the safer choice. If you have other sources of income or savings, or if you are confident in your investing ability, a lump sum may make sense. This decision is worth discussing with a financial planner before you make it.

Frequently Asked Questions

Can I collect a pension and Social Security at the same time?

Yes, you can collect both. However, if you worked in government and did not pay into Social Security, your Social Security benefit may be reduced by a rule called the Government Pension Offset. If you worked in the private sector and paid into Social Security, you can collect both your full pension and your full Social Security benefit.

What if my pension fund runs out of money?

If your employer's pension fund becomes underfunded, the Pension Benefit Guaranty Corporation (PBGC) — a federal agency — may step in and pay your pension. However, the PBGC payment is usually lower than what your original pension promised. Government pensions are not covered by the PBGC, but they are backed by the government's taxing power, so they are considered very secure.

Can I roll a pension into an IRA?

If you take a lump sum from a pension, you can roll it into an IRA to avoid immediate taxes. However, you cannot roll a monthly pension payment into an IRA — once you start receiving monthly payments, you receive them as income and pay taxes on them each year. The lump sum rollover option is only available if your pension plan offers it.

What happens to my pension if I die before retirement?

This depends on your pension plan. Some pensions pay a survivor benefit to your spouse or children if you die before you start receiving payments. Others do not. Check your pension plan documents or contact your former employer's pension office to find out what survivor benefits, if any, are included in your plan.

Do I have to work until a certain age to get my pension?

Most pensions have a minimum age and a minimum years of service before you can start receiving payments. Common thresholds are age 55 with 10 years of service, or age 62 with 5 years of service. If you leave your job before meeting these requirements, you may not receive a pension, or you may receive a reduced benefit when you reach the required age. Check your plan documents for the specific rules.