401(k) vs. pension plan: What’s the difference?

Before the passage of the Revenue Act in 1978, many companies provided traditional pension plans as retirement benefits to their employees. However, the Act’s introduction of 401(k) plans led to a decline in the use of traditional pensions for two reasons: they were complex to administer, and they placed a significant financial burden on companies. Instead, 401(k) plans became more popular, as they are easier to administer and shift more responsibility for retirement savings onto employees.

According to the Bureau of Labor Statistics, as of March 2020, only 3 percent of private industry workers had access to traditional pension plans. It is worth noting that 12 percent of workers had access to both a 401(k) and a traditional pension plan.

The difference between a pension plan and a 401(k)

A traditional pension, or defined benefit plan, is a retirement benefit provided by companies where the employer sets aside the money to invest on behalf of the employees. Employees can be eligible for a payout after meeting certain criteria like age, service and vesting requirements. The amount of their pension depends on factors like their salary over the course of their employment. Pension plans don’t require contributions from employees, and the amount of the pension depends upon the employee’s salary over the course of their employment, among other factors.

Employees covered by a pension plan will receive benefits paid for by their employer. It can be a set amount for their lifetime throughout their retirement. A reduced payment can go to a surviving spouse, or the employee can elect a lump sum payout at retirement. Either way, the risk involved in setting aside enough funds for this payout remains with the employer.

With a 401(k) plan, employees are responsible for making their own contributions toward retirement, making it a defined contribution plan. As employers are not required to contribute (even though most employers do provide a match or safe harbor contribution), the risk remains with the employee to save enough for retirement.

Some companies have set up defined contribution pension plans that combine elements of both types of plans, where the employer contributes to employee accounts and the benefit received is based solely on the resulting investment income. Employees can also contribute, and some employers might match employee contributions. This provides an employee with the ability to set aside more for retirement due to higher contribution limits.

401(k) advantages and disadvantages

Advantages

• When employees contribute to a 401(k) through a payroll deduction, they have the option to make those contributions on a pre-tax or after-tax (Roth) basis, depending on the employer. If the employee choses pre-tax, their taxable income for the year is reduced, which results in a lower tax liability.
• Employees can choose how their contributions are invested by selecting from a wide array of investment options provided by their plan. These can include mutual funds, ETFs, stocks or bonds.
• Employees can make contributions to their 401(k) plan up to the certain limit set by the IRS, and individuals who are 50 years of age or older can make additional “catch-up” contributions. The contribution limit for 401(k) plans is subject to change every year. For tax year 2022, the contribution limit is $20,500, with an additional $6,500 for employees 50 or older. In tax year 2023, the contribution limit increases to $22,500, with catch-up contributions set at $7,500.

Disadvantages

• There are risks associated with retirement savings as rate of return and lifetime income streams are not guaranteed. A 401(k) that performs poorly, or charges high fees, can negatively affect your retirement readiness.
• The amount of money available for retirement depends on the amount that was contributed, as well as whether the employer provided a match.
• The contributions you and your employer can make to a retirement plan are limited by the IRS, and the income threshold is typically lower than the limit for a traditional pension plan.

Pension plan advantages and disadvantages

Advantages

• Employees are not required to make contributions, and employers assume responsibility for investing the funds.
• Retirees receive a fixed amount of income for life, regardless of how the plan performs. If the plan falls short of meeting its obligations, the employer is responsible for covering the shortfall. In the event of an employer bankruptcy, the federal government may step in and take over the failed pension plan.
• At higher income levels, there are limits set by the IRS on the amount that an employer can contribute to a retirement plan on behalf of the employee.

Disadvantages

• Plans typically have stricter withdrawal and transfer rules with no option for taking out loans.
• Employees have no control over how the funds are invested or managed.

There is also a pension plan type that allows the employee to contribute over and above what the employer contributes. This provides the ability to set aside more for retirement due to higher contribution limits via employee payroll deduction.

401(k) or pension: Which is better?

Having a combination of both a 401(k) and a pension plan, if you are lucky enough to be eligible for both, is ideal to help manage investment risk. A 401(k) can provide variable income streams that may capture upward market movements and offer dividend earnings to counteract inflationary pressures. Meanwhile, a pension plan provides guaranteed income that lowers your exposure to market volatility and reduces the chance you will outlive your own investment savings.

Social Security is a type of pension plan that most Americans are eligible for, which guarantees lifelong payments, however it is unlikely to fully fund your retirement so it’s important you ensure you have other sources of retirement income.

Bottom line

While both plans may be available to some employees, many times only one plan or the other is offered by the employer, so the employee may not have a choice as to which plan to participate in, much less the opportunity to participate in both.

The bottom line is that employees are responsible for ensuring they have enough money saved for retirement, so even if their employer is providing a defined benefit pension plan, the employee should still be saving money in an IRA or other investment vehicle and not rely solely on the employer to provide them with a comfortable retirement.

If the employer does not provide a defined benefit pension plan, it is incumbent on the employee to save in a 401(k) or other retirement vehicle to ensure that savings, coupled with social security, will provide the individual with a comfortable retirement.

Most job seekers do not take a new job based on whether or not the prospective employer has a defined benefit pension plan or 401(k) or both, but it is something that should definitely be considered when contemplating a job change. Your retirement could depend upon it.