A pension plan is one where all contributions are made by the employer and the benefit is defined by the plan's rules. A 401(k) is a savings account to which the employee makes contributions and manages the investments in order to build a retirement nest egg.
What Is a Pension Plan?
A pension plan is also known as a defined benefit retirement plan. Defined benefit means that the benefit that someone who is covered by the plan will receive if they become vested in their benefit is defined by a set of rules. The benefit might be a function of the years worked, the compensation the employee earned while working for the employer, or other factors.
Pensions provide an ongoing, stable income for life for beneficiaries. Private sector pensions will typically not offer any sort of cost-of-living increases. Public sector and non-profit pensions often will offer this benefit.
A pension plan requires that the employer offering the plan put away sufficient funds to cover the future costs of providing these benefits to retirees and their beneficiaries, such as a spouse, upon their death.
The calculation of the liability for future benefits can be complicated and is based upon a set of actuarial rules established and revised from time-to-time by the ERISA rules under the Department of Labor. Each year a calculation is done to determine the level of funding of the plan. There are minimum levels of funding that plans need to achieve, and they may need to contribute company funds to reach these levels.
In the private sector, the liability to pay future pension benefits is a liability of the company. This liability is treated the same as a bank loan or any other type of financial liability carried on the company's balance sheet.
In recent years more and more private sector employers have frozen the benefits of their plans or eliminated them altogether due to the expense of funding and administering pensions.
Pensions are still very common in the governmental and non-profit sector. As a resident of Illinois, I am all too aware of the underfunding of many state and municipal pensions here in my state. This is an all-too common problem across the country. The bankruptcy in Detroit a few years ago put the pensions of many workers in jeopardy, settlements have been reached as to the payment of some benefits in many cases.
What Is a 401(k) Plan?
A 401(k) plan is a defined contribution retirement plan, which means that the amount available for your retirement is determined by a combination of the amount contributed by the participant in the plan and the returns on the money invested. Some employers may offer a match based on some percentage of the amount contributed by employees.
These plans are offered by many employers and the trend has been moving toward defined contribution plans versus defined benefit plans among employers in recent years.
Typically, a 401(k) plan will feature a menu of investment options across a number of asset classes that participants can choose from. Often these are mutual funds, but they can also be collective investment trusts or other types of institutional investment offerings.
Many plans will offer a managed account option such as a target-date fund. Managed accounts will typically offer an all-in-one investment option for those participants who are not comfortable making their own choices from the menu of individual funds or other investments offered.
Traditional vs. Roth 401(k)
Contributions to a traditional 401(k) account are made on a pretax basis. Many plans now offer a Roth 401(k) option as well. Roth 401(k) contributions are made on an after-tax basis and work much like a Roth IRA, with some differences, however. Note that all employer contributions to your account will be made to a traditional (pretax) account as required by the rules.
Pension vs. 401(k): Key Differences
While both types of plans can help fund retirement, pensions and 401(k) plans have a number of key differences.
Employer vs. Employee Funding
Pension plans receive all of their funding from the employer organization offering the plan. The employer is responsible for ensuring there is enough money in the account to cover current and future benefits for retirees. They are responsible for investing the money to try to meet this goal.
With a 401(k) plan, the responsibility for saving and investing for retirement falls upon the shoulders of the plan participants. While the plan sponsor does have a fiduciary responsibility to offer a solid, low-cost menu of investment choices, at the end of the day it is the responsibility of the participant to defer enough from their salary to fund their own retirement.
Defined Benefit vs. Defined Contribution
The benefit that you will receive from a pension plan is defined by a formula, a set of rules. The factors could include how long you have worked for the employer, your career earnings with the employer and perhaps other factors.
The benefit you will be able to realize in retirement with a 401(k) is defined by your contributions and any made by your employer. Under the defined contribution model, the amount of money available to you in retirement is a function of how much you contributed to the plan while working and how well the investments you chose performed.
Additional contributions to a 401(k) plan can emanate from the employer as well. This could take the form of a matching contribution based in some percentage of the money you contribute. It could also come in the form of an annual profit-sharing contribution. These contributions are optional and based on some percentage of your compensation for the year.
The amount that can be withdrawn from a 401(k) as monthly or periodic payment to support your retirement will vary based on the amount in the account, how well it is managed, etc. This contrasts with a pension where the monthly benefit is a fixed amount.
The benefits received from a pension plan are generally subject to federal taxes. Some state and municipal pension payments may not be subject to state income taxes, consult with a knowledgeable tax professional for advice on this.
Distributions from a traditional 401(k) account are subject to taxes and may be subject to a 10% penalty if you are under 59½. Distributions from a Roth account will not be taxed in most cases, but there are rules to be followed to ensure this is the case. Taxation at the state level will vary.