A 401(k) plan and a pension plan are both tools that can provide you with a dependable income in retirement. But these employer-sponsored retirement plans have some significant differences.
A 401(k) is a defined contribution plan, and a pension is a defined benefit plan. These differences determine whether the employer or employee bears the investment risks. With a 401(k), the employee bears investment risk. With a pension, the risk is on their employer. In recent years, 401(k)s have replaced pensions, which have become far less common.
In this article, learn what the crucial differences are between the two plan types.
- 401(k) plans have largely replaced pensions in today’s workplace.
- With a 401(k), the employee assumes all the risk associated with their investments.
- With a pension, the investment risk is borne by their employer.
- 401(k) investments can grow more quickly than traditional, conservative pension plans.
Why 401(k)s Have Replaced Pensions
For much of the last 50 years, pensions have become less common and 401(k) plans have been increasingly popular. Originally, 401(k) plans were not a design of the U.S. government or the Internal Revenue Service (IRS). They were created by benefits consultant Ted Benna. In 1979, Benna noticed that the rules established in the Revenue Act of 1978 made it possible for employers to establish simple, tax-advantaged savings accounts for their employees.
Employers found significant advantages in offering 401(k)s. With a traditional pension, a company promises to pay an employee a specified income during retirement. That’s why pension plans are known as defined contribution plans. This type of plan is federally guaranteed but still presents risks to employers, especially to small employers. Following a stock market crash, a company could potentially go bankrupt by the cost of paying employee pensions.
Despite 401(k) plans being originally designed to supplement traditional pensions, many companies have come to see them as a replacement. So, pensions have become less common. As of March 2021, 53% of private industry workers had access to defined contribution plans, while only 3% had access to defined benefit plans, and 12% had access to both. As of 2019, 401(k) plans covered an estimated 80 million people and held $5.7 trillion in assets. About one-third of employees had no access at all to an employer-sponsored retirement plan.
Though 401(k) plans have replaced pensions in many workplaces, they are a fundamentally different retirement plan. A 401(k) plan is a defined contribution plan, where employees assume the risks of their investments. A pension is a defined benefits plan, where this risk is borne by the employer.
401(k)s and Pensions: The Key Differences
The main differences between 401(k) plans and pensions are who carries the investment risk and who has control over investment choices.
With a pension plan, employees do not have control of investment decisions, but they also don’t assume any investment risk. Instead, contributions are made by the employer to an investment portfolio that is managed by an investment professional. In some cases, employees may also make contributions, which are either required or voluntary.
The sponsor, in turn, promises to provide a certain monthly income to retired employees for life. This guaranteed income comes with a caveat. If the company’s portfolio performs poorly, or if the company declares bankruptcy or faces other problems, benefits may be reduced. However, almost all private pensions are insured by the Pension Benefit Guaranty Corp., with employers paying regular premiums. Thus, employee pensions are often protected.
Ultimately, pension plans present individual employees with significantly less market risk than 401(k) plans. Pensions are generally considered better than 401(k)s from an employee perspective because all of the investment and management risk is on the employer and you are guaranteed a set income for life.
In contrast, a 401(k) can be more aggressively managed, and the employee controls the growth, which can be greater than that of a pension fund. A 401(k) can start earning money immediately, while a pension usually takes five to seven years before you are vested. A 401(k) is also more portable in that you can take it from one employer to another by rolling it over into a new 401(k) at your new job.
Essentially, though 401(k) plans have come to replace pensions for many workers, they are not the same. While a 401(k) theoretically offers higher growth and more flexibility, most analysts agree that this doesn’t make up for the increased market risk that it presents.
Have 401(k)s replaced pensions?
Today, your employer is far more likely to offer you a 401(k) plan than a pension. But there are important differences between these retirement plans, and you shouldn’t see a 401(k) as a replacement for a pension if you have a choice between the two.
Is a 401(k) or a pension more risky?
Both are risky, but not to the employee. With a 401(k), the employee shoulders the market risk of their investments. With a pension, this risk falls on the employer. This is one of the reasons why 401(k)s have been used instead of pensions by many employers, despite not being designed for this purpose.
Pension vs. 401(k): Which is better?
Generally, a pension is a better benefit for the employee. Though 401(k) plans can be more flexible and give you more control, they are also far more risky than a traditional pension plan, which grants you a guaranteed income in retirement.
The Bottom Line
Though 401(k) plans have largely replaced pensions in today’s workplace, there are important differences between these two retirement plans. With a 401(k), the employee assumes all of the risk associated with their investments. With a pension, this risk is borne by their employer. This typically makes pensions a better option for employees.
That said, 401(k)s can grow more quickly than traditional, conservative pension plans, and they are more flexible. By shifting risk away from employers, 401(k)s have allowed many smaller firms to offer some kind of retirement plan to their employees.