Pension vs 401(k): what's the difference?

Pension plans, which are funded by your employer, are increasingly being replaced by 401(k) plans, which are employee-funded. Learn how these plans work and what they mean for your retirement.

There are many different retirement plans that can help you save for a comfortable retirement. However, since all retirement plans have their own features and benefits, it's not always easy to know which one is which. That's why it's best to compare as many different plans as possible in order to make the right choice for you.

So what are pensions plans and 401(k)s, and what are the key differences between the two?

Pension plans are defined benefit plans that can offer a great deal of security, providing lifetime income throughout retirement. However, these plans are increasingly rare and mostly found in government agencies. Today, 401(k)s are the most prominent type of retirement plan for most private sector companies, offering employees an opportunity to save a portion of their income, tax-deferred, and investing it in one of many select program investments. Often, companies will match a portion of the employee’s 401(k) contributions. Read on for additional details and pros and cons of each type of plan.

What is a pension plan?

A pension plan (also referred to as a defined benefit plan) is a retirement account that is sponsored and funded by your employer. Retirement benefits are based on a formula that includes factors such as your salary, age, and the number of years you have worked for the company. For example, your pension benefit might be equal to 1% of your average salary for the last five years of employment, and then times your total years of service. Over the years, your employer makes contributions on your behalf and promises to make you regular, predetermined payouts every month when you retire.

Pros

Typically, pensions are a defined benefit program, which means that you will begin receiving income at the time of your retirement.
In many pension programs, payout runs for life, providing a greater degree of security, no matter how long you live.

Cons

Since the company is in control of the money, you won’t have a say in how it’s invested.
If you change jobs, you may forfeit your right to your pension since the money is not portable as it is with a 401(k).
If the company fails prior to your retirement, your pension may not be honored.

What is a 401(k) plan?

A 401k plan is a retirement account that's made available to employees who wish to save for their retirement (provided their employer offers a plan). In this case, it's the employer that withholds a part of your salary (tax-deferred) and invests those dollars on your behalf. Some employers are even willing to match the contributions made by their employees with their own money. Since 401(k) plans are meant to encourage you to save for retirement, there are tax penalties imposed for early withdrawals (before age 59½).

Pros

With a 401(k) plan, you may choose from a list of available investments, giving you more control over how the money is invested.
You may roll over your money if you change employers over time.

Cons

Your contributions are invested in market securities, so there is some volatility associated with 401(k) plans.
It’s possible to access the money and use it for emergencies or other uses prior to retirement, which may leave your retirement savings drained prior to retirement.
Pension plans typically provide ongoing retirement income, whereas 401(k) plans do not guarantee a set level of benefits.

Pension plan vs. 401(k)

A pension plan is funded and controlled by the employer, while a 401(k) is primarily funded by the employee, who may choose from a list of offerings, how the money is invested. Some employers will match a portion of your 401(k) contributions. A 401(k) allows you some control over your fund contributions, while a pension plan does not. Pension plans guarantee a monthly check in retirement a 401(k) does not offer guarantees. However, 401(k)s are portable, meaning you can roll them over into another account should you change employers one or multiple times. Pensions may only be available if you stay with that company through retirement.

Pension plans have been in existence for a long time, while 401(k)s are now more common. In fact, the 401(k) will most likely be replacing pension plans altogether in the near future.¹ However, there are still some employers who offer both a pension plan and a 401(k) plan.

Sources:

¹ Social Security Administration, "The Disappearing Defined Benefit Pension and its Potential Impact on the Retirement Incomes of Baby Boomers," October 2009.

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