The Difference Between a 401(k) and a Pension

A 401(k) is a type of retirement plan, but it’s not a traditional pension plan.

A traditional pension plan has defined benefits. The beneficiary of a pension plan (and their employer) puts money each month into the pension fund. That fund grows over the years. Eventually, the employee reaches retirement age and the fund starts to make payments.

Those pension payments will be the same regardless of how well the fund has performed. If the fund hasn’t grown enough to make those payments, the employer is responsible for making up the difference.

It’s a commitment that companies are now less willing to accept. Few institutions outside the public sector now offer pensions with defined and guaranteed benefits.

Instead, they’re moving to defined contribution plans such as 401(k)s. Each month, the employee (and the company) put a set amount of money into the fund. The amount that the fund pays out on retirement will depend on the performance of the fund. If the markets haven’t performed well, the payouts may be lower than the retiree expects.

On the other hand, if the fund and the markets have performed well, the retiree could have a higher income than they anticipated.

Defined contribution plans remove the commitment from the employer and leave retirees uncertain of the amount they’ll receive when they stop working.