401(k) vs. Pension Plan: What’s the Difference?

A 401(k) and a pension are both employer-sponsored retirement plans that promise tax advantages as well as future financial security. Both are methods of funding employees' retirement costs with real tax savings for participants. The main difference:

• A pension guarantees the retiree a set payment for life.
• A 401(k) and its cousins like the 403(b) accumulate cash until the employee retires and takes responsibility for managing the account.

In the U.S. pensions have largely disappeared from the private sector although most public workers still have them. They have been replaced by employer-sponsored plans such as 401(k)s. Self-employed people have access to similar benefits with individual retirement accounts (IRAs).

401(k) vs. Pension Plan: An Overview

A 401(k) is classified as a defined contribution plan while a pension is a defined benefit plan.

A defined contribution plan allows employees and employers (if they choose) to contribute funds regularly to a long-term account. The employee chooses how to invest the money from a selection provided by the employer. Both the employer and the employee get tax breaks on their contributions. When the employee retires, the total amount in the account is theirs.

A defined benefit plan also grows over the years with contributions from the employer and employee. The employer generally pools all contributions to be professionally invested and managed. After retiring, the employee will receive a set payment from this fund for life. The payment is based on factors such as length of service and final salary.

Who Bears the Risk?

A crucial difference between a 401(k) and a pension plan is in who bears the risk:

A 401(k) is turned over to the retiring employee, who takes on the rights and responsibilities of managing the balance of the account. If the retiree spends all the money, or if the investments lose value, it's that person's problem alone.

A pension is paid out from a fund retained by the employer. If all of its retirees live to age 120, or the fund experiences investment losses, it's the company's problem.

Who Has a Pension?

The 401(k) was originally intended by the government to be a supplement for traditional pensions rather than as a replacement. Only a lucky few have both today, and pensions are disappearing from the private sector.

As of March 2022, about 67% of private sector workers in the U.S. had defined contribution plans, while only 15% reported access to defined benefit plans. This is in stark contrast to state and local government workers. As of March 2023, 86% of state and local government workers reported having access to defined benefit plans while only 39% had defined contribution plans.

401(k) Plans

A 401(k) plan is funded primarily through regular employee contributions via paycheck deductions, up to an annual limit set by the Internal Revenue Service (IRS). Those who choose a traditional 401(k) plan get an immediate tax break, as their contributions are deducted from their gross income for the year. Those who choose a Roth plan get no immediate deduction but will enjoy a tax break down the road as they withdraw the money.

Contributed money can be placed into various investments chosen by the employer. These are typically mutual funds although stocks, bonds, and annuities may also be available. Any investment growth in a 401(k) occurs tax-deferred until you withdraw it.

Many employers offer matching contributions with their 401(k) plans, meaning they contribute additional money to an employee account up to a certain level. For example, your employer may offer a 50% match of your contributions to your 401(k) of 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.

Unlike pensions, 401(k)s place the investment and longevity risk on individual employees, requiring them to choose their own investments with no guaranteed minimum or maximum benefits.

Employees assume the risk of outliving their savings or experiencing losses in a market downturn.

Pension Plans

Employees do not make any investment decisions about a pension plan, and they do not assume the investment risk.

Instead, contributions by the employer are paid into a fund that is managed by an investment professional. In some cases, employees may also make contributions, which may be required or voluntary but the primary source of the money is typically the employer.

The employer promises to provide a certain monthly income to each retired employee for life. This amount is usually determined by the number of years an employee has worked, a final average salary based on the last three to five years of the employee’s service, and a percentage multiplier, typically 2%.

The pension must be vested, meaning that the employee is eligible to receive the full amount only after staying on the job for a number of years, often five to seven.

The main tax advantage is that you will not pay capital gains taxes on any portion of your pension although you will owe income taxes.

The guaranteed income comes with a caveat: If the company’s portfolio performs poorly or the company declares bankruptcy or faces other problems, benefits may be reduced. However, almost all private pensions are now insured by the Pension Benefit Guaranty Corporation, with employers paying regular premiums. That protects their retirees' pensions.

Ultimately, pension plans present individual employees with significantly less market risk than 401(k) plans.

Pension vs. 401(k): Which Is Better?

There are pros and cons to both plans, but pensions are generally considered better than 401(k)s because they guarantee an income for life.

A 401(k) can be more aggressively managed by the individual, which could create more growth than is likely from a pension fund. Then again, investment losses are also possible.

The earnings on employee contributions to a 401(k) are yours immediately, while a pension usually takes five to seven years to vest. (Many 401(k)s have a vesting schedule for employer-contributed funds.)

A 401(k) is portable. You can take the account from one employer to another by rolling it over into a new 401(k) at your new job. You can also roll it over into an individual retirement account (IRA).

A pension stays with the employer who provides it if you switch jobs. You must keep track of it, and when you are ready to retire, you have to apply to begin receiving your payments.

The Bottom Line

If you're working in the private sector, your employer is much more likely to offer a 401(k) than a pension in its benefits package. You can make your own decisions on investing and watch your retirement fund grow.

If you work in the public sector or for a company that still offers a pension plan, you have the advantage of a guaranteed monthly income in retirement, with the investment and longevity risk placed on the plan provider.