Although most employees may be unaware of it, there are several different forms of employee compensation that are geared towards retirement. The two most common examples are traditional pension plans and 401ks. Each of these is an example of a defined benefit plan and a defined contribution plan, respectively. However, each type of plan is different so it pays to know the advantages and disadvantages of each.
Advantages of Defined Contribution Plans (401ks)
1. Employees have more control over investing options as they get to choose which assets to have their plan's funds invested in.
2. Greater portability with funds in the plan. These funds can easily be transferred into an IRA or another retirement account.
3. Employees can actually make their own contributions out of their salary to the plan allowing for potentially greater funds to be invested.
4. Many plans allow you to make early withdrawals or borrow funds which most defined benefit plans do not allow. In fact, most defined benefit plans will not allow you to get to funds until your retirement age. This is even if you retire early in most cases.
Disadvantages of Defined Contribution Plans (401ks)
1. Trend of reduced investing options for plan. More companies are scaling back the investing options for employees. This can make it more difficultly to diversify funds or invest in the best performing asset classes.
2. Employers can reduce the percentage amount of contributions and other terms. This means you can lose the "free money" contributions if employers decide to change the plans.
3. Does not offer guaranteed money at retirement. Offers a greater risk because funds are not protected by the Pension Benefit Guaranty Corporation and the funds are largely dependent on the positive growth and performance of the stock market. In troubled times like the present, this means you can see drastic drops in the value of people's 401k plans.
Advantages of Defined Benefit Plans (Pensions)
1. Guaranteed money at retirement. This is the single biggest advantage of these pension plans because this money is promised by the employer and is guaranteed by the Federal Government.
2. No fear of making the wrong investment decisions. The high risk / reward benefit of a 401k plan can also be a disadvantage depending on how much time the employee wants to spend reviewing their account and dealing with the higher level of risk.
3. Do not have to put any of your salary towards the plan. The money is normally only provided by the employer so you keep more take home pay.
Disadvantages of Defined Benefit Plans (Pensions)
1. Reduced opportunity to score big. By preventing you from selecting investment options, the potential is there that you could miss out on a higher retirement payout.
2. Funds are held till retirement age. It is very difficult to get funds prior to your retirement age. This can be very frustrating if the need arises for funds prior to your retirement.
3. Limited Availability. It can be harder and harder to find traditional pension plans since more employers do not like having to promise to pay this guaranteed money.
By looking at the different pros and cons of pension plans and 401ks, you can see that they both offer certain advantages and disadvantages. If you have the option of selecting one or the other, you should review this list to help you decide which plan will be in your best interest.