Can You Have a Pension and a 401(k)?

If you work for an employer that offers both a 401(k) plan and a pension plan, you're in a lucky minority. Participate in both plans to the max and look forward to a comfortable retirement.

Only about 15% of employers in private industries offer defined-benefit pension plans, although 86% of state and government employers do, according to the Bureau of Labor Statistics.

Pension plans have been largely replaced by employer-sponsored retirement savings plans such as the 401(k) and its cousins like the 403(b). That's because they're cheaper for the employer to offer, and they have tax benefits for employers and employees.

In short, if you have access to both, congratulations. If you have a pension plan but no 401(k), consider investing in an IRA every year.

Traditional Pension Plans: A Blast from the Past

In the parlance of human resources departments, a pension plan is known as a "fixed benefit plan," as it guarantees the employee a set amount of monthly income for life after retirement, based on the individual's salary and number of years worked. A 401(k) is a defined-benefit pension plan that accumulates until the employee retires. At that point, it belongs to the employee and the company has no further role in funding or distributing it.

Since the late 1970s, when the government first okayed the tax breaks associated with 401(k) plans, private companies have been moving away from the fixed benefit plan and offering a 401(k) as a substitute. Self-employed people and others who were not covered by company benefits could open an Individual Retirement Account (IRA) to get a similar long-term savings account with similar tax breaks.

How Pensions Work

Until the 1970s, most workers had defined-benefit pensions. They were designed to encourage employees to stay with one company for the long haul. The employee was rewarded for loyalty, and the company benefited from having a stable, experienced workforce.

As the name implies, these plans provide a fixed ("defined") payment during retirement—for as long as you live. If you'd rather have a single payment, you can elect a lump-sum distribution. You can even choose a combination of the two options.

Either way, your benefits are based on metrics, such as your age, earnings history, and years of service. Your employer funds the pension and takes on the investment risk.

The company also bears the longevity risk. That's the risk that many plan participants will live longer—and collect more money—than the company expected.

These days, defined benefit plans are still fairly common in the public sector (i.e., government jobs). But they've largely disappeared from the private workforce, where defined contribution plans now rule.

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 receive at retirement depends on how much was contributed to the plan over the years and how well your investments performed.

While defined contribution plans were welcome creations, few realized at the time that they would eventually replace the cherished traditional pensions that employees had grown accustomed to.

Defined contribution plans are cheaper for employers to maintain and fund. They also shift the burden of retirement planning—and the longevity risk—to the employee.

For these reasons, traditional pensions are no longer part of the retirement equation for most workers at private companies.

Government Employees Still Get Pensions

Defined benefit plans are still available to most government employees at the federal, state, and municipal levels. While it may be comforting to assume your retirement needs will be fully met by a government pension, that's not a good idea.

Many state and municipal employee pension plans are facing substantial shortfalls to cover future obligations. That means your pension might not be as ironclad as you once thought. Even government employees should be making additional plans to save for retirement.

Will My Pension Be Enough?

If you have a traditional pension plan, contact your HR department to find out what amount you can expect at retirement. This is usually based mostly on a percentage of your income plus the number of years you work for your employer. It also depends on whether you have worked long enough at the company to be vested in the pension plan. Leave before the magic date and your pension rights disappear.

To figure out if your pension will be enough to retire comfortably, add your expected pension payment to your expected monthly Social Security benefit. If it's not enough—or if it's barely enough—take a look at the defined-contribution alternatives, such as a 401(k) or an IRA, to make up the shortfall.

It's wise to consider the alternatives even if it looks like you're set for retirement. You never know what will happen to your pension. And in any case, 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 pension plans establish a fixed monthly benefit at the beginning of retirement and pay that amount for the rest of your life.

While that might be very generous in the early years of retirement, you’ll begin to feel the pinch in ten years or so when your monthly benefit doesn’t buy as much as it used to.

To address this, government pensions typically have some type of cost-of-living adjustment (COLA). Still, that COLA might not address your specific needs.

COLAs are generally based on the Consumer Price Index (CPI), a general-purpose survey of changes in the prices of essential goods. However, that can work against seniors. For example, healthcare is a major component of a retiree's household budget. Price levels in that sector are rising much faster than in the general economy. If the CPI is 2%, but your personal rate of inflation is 5%, you’ll fall behind even with a COLA provision.

You Don’t Control Your Employer’s Pension Plan

A pension that looks good now can change—especially if it’s not part of a union contract or other mandate.

Your employer has control over a defined-benefit plan (subject, of course, to federal law and contractual obligations). That means your company can change its benefit calculation, reduce benefits, or even terminate the plan.

If so, your employer may arrange a payout to workers for their portions of the plan to date. However, in some cases, the funds are left in a poorly managed account that pays meager benefits until the last pensioned employee dies. Either way, you won’t get your expected monthly benefits.

There's even a chance your company’s pension plan could fail. There are some protections in place to help preserve a portion of your pension plan—but not all of it.

The Bottom Line

The future of defined benefit pensions is tenuous at best. 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 during the same year.

Other ways to prepare for retirement include building up nonretirement investments (stocks, mutual funds, investment real estate), working to get out of debt, and even investigating post-retirement career opportunities.

A traditional pension is great if you have one, but never assume that your employer has your retirement fully covered. Ultimately, the quality of your retirement is your responsibility.