401(k) vs Pension Plan - What Are the Differences?
October 7, 2020
By Rahul Iyer
Both pensions and 401(k)s are forms of employer-sponsored retirement plans, but they are not the same. Pensions were once the most popular company-sponsored retirement plan in the country. However, today, only 21% of workers participate in a pension plan, and the majority of these are state and local government workers. Pensions are still very much around, but they have gone the way of the fax machine - very few new companies in the private sector are creating new pension plans. Instead, most companies today will offer a 401(k).
Before reading on, you might want to refresh yourself on what a pension is (article link) or what a 401(k) is (article link).
What Are the Key Differences Between Pensions and 401(k)s?
Employee Funded vs Company Funded
The first key difference lies in tax law. Don't worry; you don't need an in-depth understanding of tax law to follow this section. Here's what you need to know:
Under tax law, pension plans are defined-benefit plans.
Under tax law, 401(k)s are defined-contribution plans.
All this means is that in a pension plan, the employer sets aside money for the employees and invests it on their behalf. It's entirely employer-funded. By Contrast, 401(k)s are essentially a profit-sharing plan where employees contribute to their own retirement. Sometimes the company may contribute to the plan too (employee matching).
Income After Retirement
Perhaps the most significant material difference is in how you experience the benefits of each plan. With a 401(k), you get a big lump sum when you retire. However, with a pension, you get monthly installments. There are benefits to both here. With a pension plan, you're virtually guaranteed income for life, but you can't take advantage of having one big lump sum to put towards a big purchase. With a 401(k), you can take advantage of the big lump sum, but you may deplete it sooner than you expected and end up with little money to live off. It's worth noting that some pension plans offer lump-sum withdrawals, but this is relatively rare.
With a pension plan, you, as the employee has no control over where your money is invested. With a 401(k), you have much more control over this, although not total freedom either. It's also much easier to see where funds are being invested with a 401(k) compared with pension plans. There's just more transparency built into the 401(k) system.
Which is Better?
Typically, pensions are thought of as better than 401(k)s. Some pension plans require the employee to contribute a portion of their salary each month, but this is not always the case, so you could end up with retirement income for just working as you would normally. You get lifetime income, so don't have to worry about outliving your savings. You are also more resilient to market fluctuations with a pension than a 401(k).
However, pensions are expensive for companies to maintain and make less sense in a world where people change jobs so often. With the frequency of job-hopping, many people may leave a company before their employee starts investing heavily into their pension. Unfortunately, many people will never have the opportunity to choose between the two since pensions are largely being phased out.