Pensions vs. 401(k) Plans

Getting old not only incurs new health challenges but financial risks as well. With the Social Security insurance program drawing low due to a large number of retiring baby boomers, retirement plans have become especially important to provide a livable income in old age.

Since the advent of 401(k) plans to begin in the late 70s, when a group from Xerox Corp. and Eastman Kodak Co. convinced Congress to allow their employees to invest a tax-exempt portion of their salaries into the stock market, financial experts and non-experts alike have debated the benefits of traditional pensions vs. 401(k) plans. What’s the difference between them, and which one is better?

Pensions are called defined-benefit plans, meaning the benefit amount to be paid out during retirement is defined in advance, and it’s up to the plan provider (employer) to guarantee that amount. Public-sector pension plans — those offered by government employers — tend to offer more generous benefits and often include adjustments for cost-of-living once retired.

401(k)s are called defined-contribution plans, meaning the contribution to be invested into a portfolio is defined in advance, and it’s up to the employee to make those investment decisions and take the associated risks. The amount paid out during retirement entirely depends on the performance of those investments. There is no cap on the earnings, but there’s also no floor.

Unlike pension plans, which are managed by employers, 401(k) plans can follow an employee to new companies when they change jobs, or the 401(k) funds can be placed into an IRA. This rollover feature of 401(k)s, called portability, is seen by some to constitute an advantage of 401(k)s over pensions. However, others say that pensions encourage loyalty to the company and establish lifelong employment relationships that are disappearing with 401(k)s.

It’s clear that 401(k) plans are better for employers, especially smaller companies that can’t afford to put aside the funds to establish and manage a pension plan. It’s debatable whether employees get more out of pensions or 401(k)s, and much of it depends on market conditions before and after retirement. The flexibility and portability of 401(k)s is certainly a point in their favor, but none of that matters in a depressed market, where pension plans will fare better in all but the worst cases where employers go bankrupt.

But even in the case of company bankruptcy, the law provides for certain protections. Pensions are practically guaranteed to pay out in promised amounts, within limitations, even if a private defined-benefit plan has been terminated due to an event such as bankruptcy. That’s because the law mandates that pensions are insured through the Pension Benefit Guaranty Corporation (PBGC), a part of the Employee Retirement Income Security Act of 1974 (ERISA). Because ERISA is a complex statute with many rules and procedures, anyone with questions should consult with a qualified ERISA lawyer.

The debate over pensions vs. 401(k)s is becoming less important than the predicted future, however. The fact is that employers are moving largely to 401(k) plans and pensions are going extinct, and extinction tends to settle arguments.

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Melissa Thompson

Melissa is a mother of 2, lives in Utah, and writes for a multitude of sites. She is currently the EIC of and writes about health, wellness, and business topics.