When most people examine a pension vs 401k, they are comparing a defined benefit plan to a defined contribution plan. In fact, the Internal Revenue Code (IRC) has defined pension plans as either defined benefit or defined contribution.Quick Links
So in reality we should be comparing a defined benefit plan to a defined contribution plan, not a pension vs 401k. This is where there are substantial differences.
In a defined benefit plan, the benefit is stated as an annual payment that starts at the participant’s normal retirement age that is specified in the plan. The benefit is calculated with the help of an actuary using a formula that typically includes a participant’s years of employment, annual earnings, or a combination of the two. The employer will fund the plan to a level sufficient to pay the benefit at the future date.
According to the Bureau of Labor Statistics, most pension participants in medium to large companies with defined benefit plans use a formula commonly known as “final average pay.” This formula utilizes earnings in the participant’s most recent years to calculate the benefit amount. Typically, the retirement benefit is a calculated as a percentage of the employee’s final years of compensation multiplied by the length of service. Accordingly, higher final compensation and longer length of service means a great retirement benefit.
Which is better?
Since we are no longer looking at Pension vs 401k, but defined benefit plan to a defined contribution plan, lets determine which is better. First, defined contribution plans are calculated differently. Rather than looking at a final payout, the retirement benefit is the account balance of the individual employee. This account balance results from employee contributions and any matching contributions from the employer, plus any investment returns in the account.
In a defined contribution plan, the final benefits are not guaranteed and participants bear the ultimate risk of loss as a result of poor investment performance. The most common (and best known) defined contribution plans is the 401(k) plan, which is named for the code section that provides for the plan’s tax preferences.
The 401(k) plan allows an employee to allocate a specific percentage of pay be set aside in the account and often an employer will match a certain portion of the employee’s contribution. The employee will then invest these amounts based on investment options specified in the plan document. The sum of the principal contributed (both employee and employer), investment returns (earnings or even losses) less any administrative or custodial expenses results in the ending account balance.
Is a 401k the same as a pension plan?
But both defined benefit and defined contribution plans have evolved over the years. This has resulted in what we would call “hybrid” plans that have combined the characteristics of both plans, straying away from Pension vs 401k.. The most popular of these hybrid plans is the cash balance plan.
The cash balance plan is technically a defined benefit plan under the law even though it contains features that are similar to a defined contribution plan. Cash balance plans are not specifically called out in the law, but IRS has provided guidance for their funding and administration.
Cash balance plans define the employee benefit by reference to an employee’s hypothetical account balance. The cash balance plan then uses a formula, like defined benefit formulas, to specify the pension benefit to be paid at a future retirement date.
The cash balance plan is similar to a defined contribution plan in that the specified formula uses the pension benefits as a lump sum amount rather than as a series of monthly payments. The lump sum amount is determined based on using periodic pay along with an interest credit to the participants account. Pay credits would be based on a percentage of salary (like 6%) and interest credits are often a fixed amount (like 5%) or can be tied to the yield on a specific Treasury security.