A:

The biggest difference between a 401(k) plan and a traditional pension plan is the distinction between a defined benefit plan and a defined contribution plan. Defined benefit plans, such as pensions, guarantee a given amount of monthly income in retirement and place the investment risk on the plan provider. Defined contribution plans, such as 401(k)s, allow individual employees to choose their own retirement investments with no guaranteed minimum or maximum benefits. Employees assume investment risks in defined contribution plans.

There are other differences as well, including the availability of each plan; your employer is much more likely to offer a 401(k) plan than a pension plan in its benefits package. Pensions have become less popular with the rise of defined contribution plans. This is because pensions are both more expensive and more risky to employers than a 401(k) plan. 401(k) plans also allow smaller employers, which otherwise might not have had the money to set up a pension plan, to provide retirement benefits to prospective workers.

It is much easier to move and keep contributing to 401(k) funds if you switch jobs or if your company goes through a merger. Pensions, on the other hand, are better designed for employees who stay with the same company for many years.

401(k) Plan

A 401(k) is primarily funded through employee contributions via pre-tax paycheck deductions. Contributed money can be placed into various investments, such as stocks, bonds, mutual funds, and ETFs, depending on what options are made available through the plan.

Any investment growth in a 401(k) occurs tax free, and there is no cap on the growth of an individual 401(k) account. The major drawback of 401(k)s is that there is no floor, either; 401(k)s can lose value if the underlying portfolio performs poorly. There is a greater risk/return tradeoff with 401(k) plans.

Many employers offer match programs with their 401(k) plans, meaning they contribute additional money to an employee account (up to a certain level) whenever the employee makes his own contributions.

For example, assume that your employer offers a 50% match of your individual contributions to your 401(k) up to 6% of your salary. You earn $100,000 and contribute $6,000 (6%) to your 401(k), so your employer contributes an additional $3,000 to your 401(k).

Pension Plan

Employees do not have control of investment decisions with a pension plan. Rather, contributions are made, either by the employer or by the employee, to an investment portfolio that is completely controlled by the company. The company, in turn, promises to provide a certain monthly income to retired employees based on the amount contributed and, often, the number of years spent working for the company.

The guaranteed income comes with a caveat: If the company's portfolio performs poorly, the company declares bankruptcy or faces other problems, it is possible that benefits are reduced.

Nevertheless, pension plans present individual employees with significantly less market risk than 401(k) plans. In exchange, 401(k) plans offer more flexibility and control.

RELATED FAQS
  1. When is a Roth 401(k) better than a traditional 401(k)?

    Learn the difference between Roth IRA plans, traditional 401(k) plans and Roth 401(k) plans, and when a Roth 401(k) is better ... Read Answer >>
  2. What are the differences between a Pay As You Go plan and a 401(k)?

    Compare a 401(k) plan with a pay-as-you-go pension plan; both offer investment flexibility and control by the participant ... Read Answer >>
  3. Is a 401(k) a qualified retirement plan?

    Examine the different types of qualified retirement plans, and discover if a 401(k) meets the definition of a qualified retirement ... Read Answer >>
Related Articles
  1. Retirement

    How Can You Make the Most of Your 401(k)?

    Make the most of your 401(k) plan by contributing early and taking advantage of employer matches.
  2. Investing

    Understanding 401(k)s and All Their Benefits

    A quick guide to understanding 401(k) advantages, from tax savings to shelter from creditors.
  3. Retirement

    New 401(k) Pension Rollover Rule: Pros and Cons

    Is the new rule allowing participants to roll their 401(k) balances into pensions a good idea?
  4. Retirement

    Is Your 401(k) Being Mismanaged?

    401(k) plans managed by the wrong people can be hazardous to your future!
  5. Retirement

    My Employer Doesn't Offer a 401(k). Should I Care?

    Find out what do if your employer doesn't offer a 401(k) retirement savings plan, including alternative investment options and whether to switch jobs.
  6. Retirement

    This Is Why Your Employer Should Offer a 401(k)

    Understand the unique benefits that come with a small business offering a retirement savings plan such as a 401(k) to current and future employees.
  7. Financial Advisor

    Who Wants to be a 401(k) Millionaire? (TROW)

    Want to be a 401(k) millionaire? Here are some tips to get you on the right path.
  8. Investing

    Why High Income Workers Should Be Maxing Out Their 401(k)s in 2017

    If you're pulling in a bigger salary, there are two important reasons to consider making the most of your 401(k) in the new year.
RELATED TERMS
  1. 401(k) Plan

    A qualified plan established by employers to which eligible employees ...
  2. Advanced Funded Pension Plan

    A pension plan that is funded concurrently with the employee's ...
  3. Pension Plan

    A type of retirement plan, usually tax exempt, wherein an employer ...
  4. Employee Contribution Plan

    A company-sponsored retirement plan where employees may elect ...
  5. Qualified Retirement Plan

    A plan that meets requirements of the Internal Revenue Code and ...
  6. Withdrawal Credits, Pension Plan

    The rights of an employee who has a qualified pension plan to ...
Hot Definitions
  1. Pro Forma

    A Latin term meaning "for the sake of form". In the investing world, it describes a method of calculating financial results ...
  2. Trumpcare

    The American Health Care Act, also known as Trumpcare and Ryancare, is the Republican proposal to replace Obamacare.
  3. Free Carrier - FCA

    A trade term requiring the seller to deliver goods to a named airport, terminal, or other place where the carrier operates. ...
  4. Portable Alpha

    A strategy in which portfolio managers separate alpha from beta by investing in securities that differ from the market index ...
  5. Run Rate

    1. How the financial performance of a company would look if you were to extrapolate current results out over a certain period ...
  6. Hard Fork

    A hard fork (or sometimes hardfork) is a radical change to the protocol that makes previously invalid blocks/transactions ...
Trading Center