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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