401(k) vs. Pension Plan: An Overview
A defined-contribution plan allows employees and employers (if they choose) to contribute and invest funds to save for retirement, while a defined-benefit plan provides a specified payment amount in retirement. These crucial differences determine whether the employer or employee bears the investment risks. Pensions have become less common, and 401(k)s have had to pick up the slack, despite being designed as a supplement to traditional pensions rather than as a replacement.
- A 401(k) is a retirement plan that employees can contribute to and employers may also make matching contributions.
- With a pension plan, employers fund and guarantee a specific retirement benefit for each employee and take on the risk for doing so.
- Once common, pensions in the private sector are rare and have been replaced by 401(k)s.
- The shift to 401(k)s has placed the burden of saving and investing for retirement—and the risk involved—on employees.
A 401(k) plan is primarily funded through employee contributions via pretax paycheck deductions. Contributed money can be placed into various investments, typically mutual funds, depending on the options 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 account. But unlike pensions, 401(k)s, place the investment and longevity risk on individual employees, requiring them to choose their own investments with no guaranteed minimum or maximum benefits. Employees assume the risk of both not investing well and outliving their savings.
Many employers offer matching contributions with their 401(k) plans, meaning they contribute additional money to an employee account (up to a certain level) whenever the employee makes their own contributions.
For example, assume 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.
There is a limit to how much you can contribute to a 401(k) each year. In 2020 and 2021, the most an employee can contribute is $19,500, or $26,000 if they are 50 or older.
Employees do not have control of investment decisions with a pension plan, and they do not assume the investment risk. Instead, contributions are made—either by the employer or the employee, often both—to an investment portfolio that is managed by an investment professional. The sponsor, in turn, promises to provide a certain monthly income to retired employees for life, based on the amount contributed and, often, on 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 it faces other problems—benefits may be reduced. Almost all private pensions are insured by the Pension Benefit Guaranty Corporation, however, with employers paying regular premiums, so employee pensions are often protected. Pension plans present individual employees with significantly less market risk than 401(k) plans.
While they are rare in the private sector, pension plans are still somewhat common in the public sector—government jobs, in particular.
Arie Korving, CFP
Korving & Company LLC, Suffolk, Va.
A 401(k) is also referred to as a "defined-contribution plan," which requires you, the pensioner, to contribute your savings and make investment decisions for the money in the plan.
You thus have control over how much you put into the plan but not how much you can get out of it when you retire, which would depend on the market value of those invested assets at the time.
On the other hand, a pension plan is commonly known as a "defined-benefit plan," whereby the pension plan sponsor, or your employer, oversees the investment management and guarantees a certain amount of income when you retire.
As a result of this enormous responsibility, many employers have opted to discontinue defined-benefit pension plans and replace them with 401(k) plans.
The Bottom Line
Your employer is much more likely to offer a 401(k) than a pension in its benefits package. If you work for a company that still offers a pension plan, you have the advantage of a guarantee of a given amount of monthly income in retirement and investment and longevity risk placed on the plan provider. If work for a company that offers a 401(k), you'll need to take on the responsibility of contributing and choosing investments on your own.