What's the difference between a pension and a 401(k)?

• A pension is a steady-income retirement plan that's funded in your working years by your employer.
• A 401(k) is a tax-advantaged plan funded with contributions from your paychecks.
• A 401(k) plan offers more personalized retirement savings, while a pension makes guaranteed payouts.

With the rise of individual retirement accounts like 401(k) plans and IRAs, pension plans have fallen out of favor at most companies. But that doesn't mean they don't have anything to offer. In fact, pensions are still a great retirement savings opportunity.

But can they compete with 401(k) plans? Find out below where we cover what a pension plan is, what a 401(k) is, and the pros and cons of each so you can distinguish which one might make sense for you.

Pension vs. 401(k): At a glance

A 401(k) and a pension are both a type of retirement plan. However, they vary greatly in how money is placed into each plan and how that money is handled. Pensions place much of the responsibility into the employer's hands, while 401(k) plans require employees to take a more active role in planning and saving for retirement while lowering the cost for the employer.

• A pension is an employer-funded retirement plan that your employer invests and provides monthly payouts to you in retirement.
• A 401(k) is an employer-sponsored retirement plan that you control and contribute your money to.

Quick tip: Always check whether your employer or a potential employer offers a retirement savings plan. There could be free money available to you.

What is a pension?

A pension is a retirement plan that your employer funds throughout your employment to later distribute monthly payments to you once you retire. A pension is characterized as a defined benefit plan because of the guaranteed monthly payments it provides. Nowadays, pensions aren't as widely offered by employers in the US - but they're still offered by certain government entities or larger, more established companies.

Employers set up and contribute money to pensions on behalf of employees and invest that money however they see fit. When you retire, the pension pays out a set amount each month throughout your retirement.

Free money and guaranteed payouts sound ideal, but there are some drawbacks to pensions, too.

One other major drawback of a pension: You cannot bring a pension with you if you switch companies. That means you'll have to stay at a company for a certain number of years to take advantage of the pension.

While pension payouts are guaranteed, it's not assured that those payments will cover all your expenses in retirement. "Pension opportunities are a good supplement, but I recommend opening another retirement account on the side before you retire," says Liz Young, the head of investment strategy at SoFi. "That gives you a better chance to meet your quality of life in retirement."

Pension funds are also not adjusted for inflation since you get the same dollar amount each month over the years. With inflation, the purchasing power of that monthly amount decreases.

Quick tip: Pensions may be going out of style in favor of 401(k) plans, but if your employer offers a pension plan, take it. It's a great way to supplement your retirement income.

Example of a pension

Generally, you have to work for a certain number of years and reach a certain age before you're able to collect pension benefits. Your employer will calculate the amount you receive based on your age when you start receiving payments, how many years you worked for the company, and your earnings while you worked there.

For example, your employer may take your average salary for your last five years of service, multiply that by the total number of years you worked there, then pay 1% of that amount to you each year in retirement. If you worked for the company for 25 years and your salary averaged $80,000 over your last five years, you'd receive $20,000 a year.

What is a 401(k)?

A 401(k) plan is known as a defined contribution plan, since there is an established contribution system but no guaranteed payout amount. Many, but not all, employers offer 401(k) plans; you may have to elect to participate while others automatically enroll you. 401(k) contributions are pulled from your paycheck before taxes. Contributions are typically expressed as a percentage of your income.

While a 401(k) places the burden of retirement savings onto an individual, there's the benefit of flexibility. For example, employees can choose how much to contribute - up to certain limits - and choose what they want to invest in from the account custodian's offerings.

"If you're an aggressive investor, and you have a 401(k) that's properly invested and diversified that it's hopefully beating inflation, there's a bigger upside there than to a pension," says Kathleen Kenealy, Certified Financial Planner and director of financial planning at Boston Private, a Silicon Valley Bank company.

Employers may still contribute to employees' retirement savings through a 401(k) employer match. This is where they match your contribution often up to a certain amount. You can also roll over 401(k) savings from previous jobs into your current 401(k) or another retirement account.

Quick tip: Many employers offer a 401(k) matching program, which you should sign up for to get additional funds for your retirement account.

Example of a 401(k)

Let's say your employer offers a match of 100% up to 6%. That means that if you contribute 6% of your pay or lower, your employer will also contribute that amount.

However, you want to start slowly for now with a 401(k) contribution of 2% per paycheck. With a $2,000 pre-tax paycheck, each contribution would be $40. Assuming two paychecks per month, you would have contributed $960 in a year; with your employer match, your contributions would total $1,920.

After some calculations, you realize you can bump up your contribution to 6% per paycheck, or $120. Now, again assuming two monthly paychecks, your 401(k) will have $5,760 in contributions after a year of maxing out your employer match. That's not even accounting for the investment returns your 401(k) is likely making.

The financial takeaway

Although pensions are a rarity, if your employer offers a pension plan, experts suggest you take advantage of the free savings and guaranteed retirement income. You should supplement that with other retirement savings, though, like with an IRA.

As the more popular employer-offered account nowadays, you're likely to run into a 401(k) at some point, and you'd be wise to maximize that opportunity as best as you can. Contribute as much as you can on your own and take advantage of your employer match if that's offered. Don't forget to pay attention to your investments as well, and do so over time, so that your investments and returns are optimized as much as possible.