In the USA, two retirement plans come under the Employee Retirement Income Security Act (ERISA) –
- 401(k) plan (defined-contribution plan)
- Pension Plan (defined-benefit plan)
Both are employer-sponsored retirement plans but work in different ways.
A 401(k) plan allows employees and employers (depending on their choice) to invest funds for retirement savings. On the other hand, in the pension plan, the employer provides a specific payment amount. This differentiates the two plans.
As a pension plan is a defined benefit plan, it promises a fixed benefit to be received every month at retirement. It can be an exact amount, or, more commonly, it can be calculated through a plan formula based on salary and service, say 1% of average salary for the previous ten years of employment. Typically, you need to work with the employer for a fixed duration. The PBGC (Pension Benefit Guaranty Corporation) protects this traditional plan within certain limitations.
A 401(k) plan is a defined contribution plan and does not possess a fixed amount. The retirement income depends on your and possibly your employer’s equal contributions. You make investments on your own; thus, your account balance changes by market gains or losses.
Pension Plans vs 401(k) Plan – the difference
- Here, you know your exact retirement income; thus, you can prepare a budget accordingly. A 401(k) does guarantee the same fixed income after retirement.
- With pension plans, you need not contribute for retirement. Your employer bears all of the risk to offer you retirement benefits. They are solely accountable for your investments. You will receive a specific payment regardless of investment performance. On the other hand, 401(k) plans can not offer such certainty.
- Under the pension plan, an employer is obligated to pay regular premiums to PBGC and can be more complex and costly to administer. In comparison, 401(k) plans do not impose such obligations. Therefore, only 26% of workers have access to pension plans.
There are contribution limits for 401(k) plans. At present, employees can contribute up to $19,500 annually. A 401(k) account holder aged above 50 can add a maximum of $26,000.