401k & Pension Plans: What’s the Difference?

Retirement planning is a crucial aspect of personal finance, and understanding the difference between a 401k and a pension plan is essential for every investor.

In this article, we will explore the differences between the two types of retirement plans, and why 401k plans have become more popular than pensions in recent years.

Defined Contribution vs. Defined Benefit Plans

Matt Frankel, a certified financial planner, explains that retirement plans can be categorized into two types: defined contribution plans and defined benefit plans. A 401k is a form of defined contribution plan, where the contributions are well-defined, but the benefit is not.

This means that the employee contributes a set amount, such as five percent or six percent of their salary, but the eventual benefit depends on the market’s performance.

On the other hand, a pension is a form of defined benefit plan, where the benefit is set, and the employee knows exactly what they will receive for the rest of their lives.

The benefit is determined by a formula that takes into account factors such as the employee’s income, years of service, and age.

The Shift from Pensions to 401k Plans

Pensions were once a common retirement plan offered by large companies, but they have become less popular over time. Matt explains that this is because pensions are a liability on the employer’s balance sheet, and companies don’t want to take on that risk.

With a 401k plan, the employer can set a fixed amount of contribution and have no further liability for the employee’s retirement.

Interest rates have also played a significant role in the shift from pensions to 401k plans. Pension plans are predicated on the assumption that they can generate a certain return on their investments over time.

However, when interest rates dropped to historic lows, pension funds could not generate enough returns to pay out benefits. This led to a significant exodus from pension plans, as employers sought more visibility into their long-term liabilities.

The Benefits of 401k Plans

While 401k plans may be more uncertain than pensions, they offer several benefits. For one, employees have more control over their investments. This can potentially lead to higher returns over time.

Additionally, 401k plans are portable, meaning that employees can take their plan with them when they leave a job.

Conclusion

While pensions and 401k plans have their respective benefits and drawbacks, it’s clear that the world is moving towards more defined contribution plans. As Matt Frankel explains, “the world is moving to more defined contributions, so 401ks and pensions are kind of a thing of the past at this point.”

As the shift from pensions to 401k plans continues, what steps can employees take to ensure that they have enough saved for retirement, and how can they mitigate the risks associated with defined contribution plans?