What’s Your Plan?

Richard Quinn

ARE PENSION PLANS superior to 401(k) plans? I have a soft spot for my pension plan, especially when that payment hits my checking account each month. But pension plans were never as common as people imagine—and, for today’s workers, 401(k) plans may be a better bet.

The traditional defined benefit (DB) pension plan is all but gone from the private sector. Companies have terminated them, frozen them for new hires or converted them to so-called hybrid plans, which are technically DB plans, but they look more like a 401(k).

When I worked in employee benefits, I oversaw the introduction of a hybrid plan—a cash balance plan—in 1995. The plan was for new hires and it still exists. Workers receive a percentage of pay into a notational account, with the percentage based on their years of service and their age. Participants can see their account’s value grow. The funding is the same as any DB plan and the standard payout option is a life annuity. But during all the years I managed the plan, employees elected a lump sum every time, thereby voiding the idea of a pension. In other words, it was supposedly a pension plan, but many employees thought of it more like a 401(k).

Many Americans never had a pension plan. The peak was about 60% in 1960 and now it’s between 4% and 15% in the private sector. The percentage varies based on the definition used. Some workers have both a DB plan and a 401(k) or similar plan. The 4% represents those with only a defined benefit plan. By contrast, DB pensions are far more common in the public sector, with participation at perhaps 77%. But again, the percentage varies by survey.

If you consider those with any type of retirement plan—pension plan, 401(k) plan or something else—the numbers are roughly 50% private sector and 80% public sector. I see some irony here. Few Americans have a pension, many have no employer plan, and many struggle both to save for retirement and to live on Social Security once retired. Yet all Americans pay taxes, especially state and local taxes, which then fund fairly generous pensions and benefits for the public sector.

Although workers tend not to think about it, a pension is part of their total compensation. In the absence of a pension and other benefits, cash compensation should—in theory—be higher. How much is a pension worth to employees? An employer can fund a good DB pension plan for about 8% of payroll.

Yet reductions in employee benefits never seem to result in higher compensation. In all my decades managing employee benefit programs, I never saw a benefit reduction, including termination of a pension plan, translate into higher cash compensation. In today’s world, cuts are routinely made in health benefits, but those savings never seem to end up in pay.

A 401(k) or similar defined contribution (DC) plan has the potential to provide a good retirement income. In fact, I’d argue that a DC plan is now better for most workers. Why? To get value from a DB plan, you need longevity with an employer. But today, the average tenure at one employer is about four years. That isn’t sufficient time to become vested in a DB plan, let alone accumulate a meaningful future benefit. Dinosaurs like me who worked for one company for 50 years are truly extinct—but we have good pensions.

According to Fidelity Investments, the average employer contribution to a 401(k) plan is up to 4.7%. If you include that employer contribution, saving at least 10% of income on a tax-advantaged basis should not be that hard for anyone with a fulltime job. But to get value from a 401(k), you need to contribute at least enough to get that full matching contribution—and you need to keep the money in a retirement account when you change jobs, rather than cashing out your 401(k) and spending the money.

But what about the big payoff from a pension plan—that monthly check you get in retirement? That is indeed a crucial difference between the typical DB and DC plan. A pension comes with a life annuity, whereas a 401(k) plan leaves you with a lump sum.

Today, annuities within a 401(k) are possible, but rare. Congress is attempting to encourage more annuities by lowering the fiduciary risk for plan sponsors. But even if that happens, we have a long way to go—because many folks resist the idea of annuitizing. Indeed, whether folks have a pension plan or a 401(k), they seem to prefer a lump sum payout to regular monthly income.

The most common argument I routinely heard against purchasing an annuity with a 401(k) balance is, “I’ll lose the money if I die early.” True. But the fact is, if you’re dead, what you’ve lost is irrelevant. Instead, at that juncture, what matters are your spouse and any children still at home. They can be covered by a “joint and survivor” annuity that continues making payments to your surviving spouse.

Moreover, you face similar risks if you have a DB plan. While working at an employer with a pension plan, you have, in theory, given up 8% or so in cash compensation for that pension. What if you switch jobs before vesting or you die early? Like the annuity buyer, you’ve also left money on the table. Maybe that’s why pension plan participants, when offered a choice, so often opt for a lump sum. Result: They spend their retirement with the same financial uncertainty suffered by those who funded 401(k) plans and then refuse to annuitize.

Richard Quinn blogs at Before retiring in 2010, Dick was a compensation and benefits executive. His previous articles include Staking Your ClaimWhat Do You Mean and Open Season. Follow Dick on Twitter @QuinnsComments.

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Mik Barbasol
Mik Barbasol
3 years ago

401k plans have principal/market loss risk…defined benefit plans not so much…choose wisely.

Francis Sam
Francis Sam
3 years ago
Reply to  Mik Barbasol

You’re spot on. And while defined benefit plans may not suffer as much from market risk but they are subject to the risk that whoever (eg company, state, county) promised you these benefits won’t be solvent or make profits long enough to pay you those benefits.

Lots of states and counties right now have underfunded pension obligations either because they hoped the market would take care of the rest or they simply promised too much. I imagine they may cut pensioneer benefits, raise taxes, cut services (eg police, firefighters, teachers) or a combination to try and live up to these promised benefits.

I believe GE DB pensioneers are experiencing this same risk right now as well.

David Baese
David Baese
3 years ago

Richard – I’d like to read what you think about the risk of inflation to the annuity payments from a defined benefit plan.

Roboticus Aquarius
Roboticus Aquarius
3 years ago

I love my 401K. My employer can go bankrupt and all the money in my 401K will be untouched… unlike my (very tiny) pension (which I will annuitize, since I have access to some really nice payouts through my employer.)

I like the idea of annuitizing to cover expense ‘needs’. Anything beyond the basic needs can be met with 401K withdrawals. However, I’m more likely to do a SPDA type annuity at 65 or so, to start at 80 or so, just to lock in ongoing cash flow should I live really long. I think that kind of annuity is actually called a DIA, because of the 15 year gap from purchase to payout initiation, and it’s usually relatively cheap.

3 years ago

Conceptually, I prefer the defined contribution plan, which accounts for all of our retirement savings except for a small pension.
In addition to guaranteed income, the main advantage of defined benefit plans has been that they typically provided higher income than defined contribution plans (hence the larger cost to employers and the incentive to move to defined contribution plans). Along with shifting risk to employees, defined contribution plans make it much more difficult for employees to estimate their retirement income and, thus, much less likely that they will complain about the size of their employer’s contribution.

3 years ago

Are pension plans superior to 401(k) plans?

As one of my favorite professors would say: Who cares? It depends!

Generally speaking, a non-contributory defined benefit pension plan, with immediate eligibility, a super lucrative final average pay formula, early retirement subsidy and post retirement COLA, well funded by the plan sponsor will have LESS value to the majority of America’s workers when compared to your everyday 401(k) plan – immediate eligibility, automatic enrollment, 50% employer match on the 1st 6% of pay, with 15 institutional investment options.

How can that be? Simple. A typical, generous, non-contributory, DB pension plan would prefer to allocate as much of the benefit as possible to “retirees” – those completing five or more years of service, hence the plan sponsor would utilize five year “cliff” vesting using what’s called the elapsed time method. Leave before completing 60 months of service, you get nothing.

For comparison, most 401(k) plans fully vest employees in their employer’s contribution within the first three years of service.

So, because the median worker in America, under age 65, has less than five years of tenure, and because that has been true, consistently, for more than the past FIVE decades, more, many more will vest in the employer contribution to the 401(k) while most workers would not vest in the defined benefit pension. The majority of workers eligible for the DB plan will have nothing, NOTHING to show for their service.

Of course, if more employers offered DB pension plans, worker’s employment decisions might change and more might stick around to complete 60 months, just to vest. However, if you are an employer, the last thing you may want is for workers to stick around just because they need to in order to vest in your pension plan.

3 years ago

When employers close down or reduce a defined benefit plan they are in effect transferring the investment risk to the employee along with the responsibilities associated with that aspect.

Defined benefit plans serve as a spendthrift protection. One receives the money at retirement, disability or death (to the spouse or designated beneficiary). The money isn’t available for that trip to Tahiti or for a new car- a good thing.

How many employees are savvy enough to make the important decisions when it comes to investing money for the future? A very small minority.

In a DB plan the Pension Benefit Guarantee Corporation (PBGC) makes sure that the pension plan is being operated properly with enough contributions and appropriate investment to guarantee that the employee will receive the promised amount stated in the plan documents.

What we see now is a retiree catastrophe slowly taking place. Folks more and more need to keep on working into their 70s and beyond because they didn’t save enough to retire. That wasn’t the case when DB plans were more the rule than not.

Those cohorts without any or with inadequate sources of retirement income will just add to the lower socioeconomic multitude.

JP Carsten, Certified Employee Benefits Specialist (CEBS)

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