PENSION PLANS are 'DEFINED BENEFIT' retirement plans wherein the beneficiary is assured of a certain 'pension' or 'retirement benefit' paid usually on a regular basis. As is apparent from the name itself, the emphasis is on the 'pension' or the 'defined benefit'. These plans are usually funded by contributions by the employer. Alternatively these plans can also be unfunded, with the pension payments of retired employees being financed by fresh revenue receipts of the employer.
401 (k) PLANS are 'DEFINED CONTRIBUTION' retirement plans wherein the contribution of the employee ( and /or the employer) is defined, but the final benefit is variable (unlike pension, when it is fixed, usually as a percentage of last pay and depending upon the number of years served). These are called 401 (k) because they are regulated by the section 401 (k) of the Internal Revenue Code, which lays down the tax benefits that are available to them along with the rules that need to be followed for availing of those tax benefits.
Both of these plans are employer-sponsored retirement plans that serve to facilitate retirement planning of the employees and are regulated by the usual rules and regulations in this regard. But there are many subtle and significant differences, which make them more or less favorable for certain situations.
PENSION PLANS vs 401 (k) PLANS - A DETAILED COMPARISON
1. Pension plans provide fixed. pre-established benefits to employees after they retire, 401 (k) plans do not assure any benefits.
2. Pension plans are primarily funded by the employer. 401 (k) are primarily funded by the employees, though there may or may not be contributions from the employer.
3. Pension plans do not define any specified contribution. In case of funded pension plans, the contributions of employer is determined by an 'actuary' and may change from time to time depending on the market conditions. In contrast, contributions in case of 401 (k) plans is specified and does not need intervention by any actuary.
4. Pension plans are usually controlled by the employer, and therefore to protect the interest of employees, they need to be regulated by a third party, an actuary. On the other hand, 401 (k) plans are held as 'individual retirement account' or IRA where the individual beneficiary is in full control, and can also choose the assets in which she wants her contributions to be invested.
5. Pension plans suffer from the risk of employer bankruptcy, which may become a problem even in case of funded plans, if part of the funds are invested in employer company's shares. In such cases, there may not be enough assets for payment of any benefit, and the employees do not have any options of managing this risk. In case of 401 (k) plans, the employees can decide how they want their contributions to be invested and so have an option to avert this risk.
6. In case of Pension plans, market downturns leading to fall in value of investments will not affect the benefit and this risk will be borne by the employer or the insurance. In case of 401 (k) plans, market downturns will reduce the retirement benefit available to the employees.
7. In case of pension plans, the contribution of the employer is determined by the actuary, and is not subject to restrictions. In case of 401 (k) plans, the maximum amounts that can be contributed by the employee and the employer are restricted by Internal Revenue Code. The maximum limit for employee contribution is $ 15,500 while the maximum limit for total contribution made by the employee and the employer is $ 46,000 for the year 2008.
8. Pension plans can be established by any employer, while 401 (k) plans can not be established by Governmental employers after 1986.
Both pension plans and 401 (k) plans provide an avenue for pre-tax benefits of contributions made for investment for retirement planning. In case of pension plans, the contributions are usually made by the employer, which are not taxed in hands of employee, while in case of 401 (k) plans, the contributions made (within limits prescribed) are not taxed.
PENSION PLAN vs 401 (k) PLANS : PROS & CONS
PENSION PLANS - They have the advantage of allowing an assured benefit irrespective of economic downturns, thereby providing greater assurance. Downturn is that to meet the obligation of fixed benefit, the employer may have to incur huge costs that may destabilize its financial health and even lead to its bankruptcy, thereby making the assurance of pension meaningless. The cost of administering pension plans is very high. The employees do not have any control, and hence may feel dissatisfied. The need for involving an actuary for determining contributions is also costly and complex. In case of employees shifting from one employer to another, the calculations for vesting become even more complex and lead to problems for all parties. One advantage is that they can provide a higher retirement benefit as the restrictions of section 401 (k) of Internal Revenue Code do not apply.
401 (k) PLANS - Their major advantage is that they allow the employee to take full control of his retirement benefits. Another major advantage lies in their simplicity. The IRAs are easy to operate and do not pose a problem in case of movement of employees from one employer to another. They are also protected by the risks of employer bankruptcy. However, the negative side is that there are restrictions on maximum contributions, which limit the benefits. Another disadvantage is that in case of economic downturns the values of investments can go down, even lead to negative returns thereby affecting the retirement planning.
CHOICE OF PLAN
Most defined benefit plans are now being converted to defined contribution plans. The number of defined benefit plans has come down from 114,000 in 1985 to 38,000 in 2005, as per the Pension Benefit Guarantee Corporation. So most employers and employees actually prefer the defined contribution plan like the 401 (k) plans. One very big reason for this is the simplicity of IRA plans, and the control they give to their employees. However, the pension plan can still be preferable in some cases, like when the employees want to have a higher retirement benefit, as the pension plans allow the employers to make a higher contribution. They may also be preferable when the risk of employer bankruptcy is virtually absent, as in the case of the government.