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.
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).
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.
The Advisor Insight
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. Therefore, you 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) type plans.
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