February 2022 - Ferguson-Johnson Wealth Management

401(k)s and Pension Plans: What’s the Difference?

By Jon Powell, CFP^®

With many kinds of retirement plans out there, it can be hard to tell the differences among them at first glance. Two of the most popular types of retirement plans offered by employers are the 401(k) plan and the pension plan.

An employer typically provides one or the other, but not both. While it’s unlikely that you’ll have a choice between the two, you’ll probably come across one of these plans throughout your working years, so it’s essential to understand how they work and what they mean for your retirement.

What Is a 401(k)?

A 401(k), or defined-contribution plan, is a common retirement plan offered by employers. With a 401(k), you elect to contribute part of your salary into a retirement account. You can choose from a range of investments such as index funds, mutual funds, and target-date funds.

You also have the ability to change your investments, however, they are limited to the investments your employer offers. You can contribute up to $20,500 (as of 2022) each year, and if you are 50 years of age or older, an additional $6,500 catch-up contribution.⁽¹⁾

Your employer may also choose to match your contributions up to a certain amount. The total limit for employee and employer contributions is $61,000.

There are two types of 401(k) plans: a traditional 401(k) and a Roth 401(k). In a traditional 401(k), your contribution is taken from your salary pre-tax. Your traditional 401(k) grows tax-deferred, and you only pay taxes when you withdraw from the account in retirement.

Because these contributions are tax-deferred, contributing to a traditional 401(k) means you lower your taxable income at the time you contribute.

A Roth 401(k) is funded with money after you’ve already paid taxes on it. The money in your Roth 401(k) grows tax-free in your account, and since you’ve already paid taxes on your contributions, when you withdraw funds, you withdraw them tax-free.

Thus, the key difference between the two boils down to when you pay taxes. If your employer offers both, you need to decide whether it makes sense for you to pay taxes now or when you retire.

401(k) plans are also generally subject to required minimum distributions, meaning you will need to begin withdrawing from your plan when you reach age 72.⁽²⁾

What Is a Pension Plan?

A pension plan, or a defined-benefit plan, is an employer-sponsored plan that guarantees an amount of income in retirement. The amount you receive in retirement is determined by a few factors, such as your length of employment, your salary, your age at retirement, and any other specifications set by the employer.

Your employer is responsible for contributing to the plan and all the investment risk is on them as well. However, you may need to work several years at the organization before you are eligible for a pension plan. Additionally, with a pension plan you have no control over how it’s invested.

Depending on the plan, you may be allowed to contribute part of your salary as well. You are also guaranteed regular payments for the rest of your life, though the plan might offer you the choice of a lump-sum payment.

Which Plan Is Better: 401(k) or Pension Plan?

Both plans have their advantages and disadvantages. Pension plans have been around longer, however, 401(k) plans are much more common today. In fact, as of March 2021, 52% of employees had access to a defined-contribution plan such as a 401(k), while only 3% had access to only a pension plan (12% had access to both).⁽³⁾

If you have a 401(k), it is up to you to save for your retirement. You have more control but more responsibility as well. With a pension plan, your employer is responsible for funding the plan.

If you like knowing you will have a guaranteed income in retirement and prefer not having to contribute any of your own money, a pension plan will be more attractive to you. If you’d rather have more control over how much you put toward retirement, a 401(k) may be a better fit for you.

Setting Yourself Up for Success

Planning for retirement can feel daunting—but you don’t have to figure it out all by yourself. Choosing the right partner as you plan for the future can help you set yourself up for success in retirement. And finding a financial advisor that understands your unique situation and goals doesn’t have to be difficult.

At Ferguson Johnson Wealth Management, our mission is to simplify navigating the complexities of retirement, helping you plan wisely so you can live fully.

We understand that retirement plans are not one size fits all. That’s why we work with you to develop a plan tailored to your needs. Reach out to us at 301-670-0994 or by email.

All-Time Highs & The Lows That Sometimes Follow

“Every past decline looks like an opportunity; every future decline looks like a risk.”

-Morgan Housel

As we close the book on 2021, another year of generally excellent investment returns, we revisit the recurring anxiety of “what if this is the peak?”

It’s certainly not an uncommon feeling. Many investors may think a market high is a signal that stocks are overvalued or have reached a ceiling. However, they may be surprised to find that the average returns one, three, and five years after a new month-end market high are similar to the average returns over any one-, three-, or five-year period:

Source: Dimensional Fund Advisors, S&P 500 Index Returns 1916-2021.

Reaching a new high doesn’t mean the market is destined to retreat. Stocks are priced to deliver a positive expected return for investors, so reaching record highs regularly is the outcome one would expect. New highs are necessary for long-term investors to make money in the markets.

As such, it’s a good thing that markets have been constantly achieving new highs. Here’s the number of new all-time highs that were hit per year over the past decade:

Year	# of New Closing Record Highs
2012	0
2013	45
2014	53
2015	10
2016	18
2017	62
2018	19
2019	36
2020	33
2021	70

Source: Morningstar S&P 500, 1/1/2012 – 12/31/2021.

As I’m sure you’re aware, January has been anything but kind to investors, so far – seemingly refuting the evidence laid out above. But, we know when investing in financial markets that drawdowns are a possibility. Much like the regularity of new market highs above, we see regularity with market drawdowns, as well.A new all-time high isn’t a unique occurrence or uncharted territory – it’s kind of the norm.

Going back to 1950, we have seen a drawdown of at least 5% in nearly every year. Even declines of greater than 10% have been observed in most calendar years.

Magnitude of Decline	Frequency
5% or more	96% of years
10% or more	62% of years
20% or more	25% of years
30% or more	10% of years
40% or more	4% of years

Source: Morningstar S&P 500, 1/3/1950 – 12/31/2021

There’s a lot weighing on markets: Will inflation continue? Will the Federal Reserve tighten monetary policy, raising interest rates? Will new tax legislation ever happen? What about COVID? Climate change? China? Tensions around Russia and Ukraine? Cryptocurrencies? Meme stocks? SPACs?

I get it – It’s a lot. But, it’s always a lot. Remembering the Morgan Housel quote at the top: “Every past decline looks like an opportunity; every future decline looks like a risk.”

Less than two years ago, we were in the early days of the COVID-19 Pandemic. People were afraid to leave their house. We left packages by the front door for several days to “disinfect”. We stood around in socially-distanced circles with neighbours for “happy hour” on Friday evenings (I kind of miss that part of it, actually).

Anyway, the S&P 500 fell 34% in the span of a month. Since then, the index had gained 114% to the most recent high that was hit on January 3^rd1. Unintuitively, it turned out to be a marvelous investment opportunity, but it certainly didn’t feel that way in the moment.

The markets today may seem scary. The truth is the magnitude of a correction, when it will occur, and how long it will last is unknown. Have we already taken the first steps toward a depression?

Or will we be achieving new highs again in February or March? I can’t say. I’m pretty confident that however things play out, we will look back on this period with the same attitude of “well, that ended up being a good investment opportunity.”

We allocate the investment portfolios we build based on the capacity each individual client has to bear risk. Those portfolios are built with the expectation of declines. The financial plans are built with the expectation of declines.

The retirements we forecast are not an elaborate house of cards that fold as soon as the wind changes direction. If the anxiety and worry become too much to handle, then let’s explore what it really means for you.

¹ Source: Morningstar. Data from 2/19/2020 to 12/31/2021.

What Is a 401(k)?

What Is a Pension Plan?

Which Plan Is Better: 401(k) or Pension Plan?

Setting Yourself Up for Success

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