The traditional three-legged stool of retirement—employer-provided pension, Social Security, and personal retirement savings—includes 401(k) plans and traditional pension plans. 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.
401(k) vs. Pension Plan: An Overview
Defined-benefit plans, such as pensions, guarantee a given amount of monthly income in retirement and place the investment and longevity risk on the plan provider. Defined-contribution plans, such as 401(k)s, place the investment and longevity risk on individual employees, asking them to choose their own retirement investments with no guaranteed minimum or maximum benefits. Employees assume the risk of both not investing well and outliving their savings.
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 common, and defined-contribution plans have had to pick up the slack, despite being designed as a supplement to traditional pensions rather than as a replacement.
- 401(k) plans and pensions are two legs of the three-legged stool of retirement: workplace pension, Social Security, and personal retirement savings.
- Pensions provide guaranteed income for life, with the employer taking the investment and longevity risk.
- 401(k) plans place all the risk in the hands of individual employees.
- 401(k) plans were designed as a supplement to traditional pensions rather than as a replacement, though that is what they are now being asked to do.
Understanding the 401(k) Plan
A 401(k) plan is primarily funded through employee contributions via pretax paycheck deductions. Contributed money can be placed into various investments, such as stocks, bonds, mutual funds, and exchange traded funds (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 a 401(k) plan 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 matching 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 or her 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).
There is no longevity protection with a 401(k); if you outlive your savings, you will not receive any more money.
Understanding the Pension Plan
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, it is possible that benefits will 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.
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.