Is a 401k plan better than a pension? For most workers, it is. Here’s why

The 401k plan is often maligned by pension and retirement advocates. There’s is no guarantee with a 401k and it requires participants to take responsibility, contribute and to take the investment risk. That’s all true but there is more to the story.

I live on a pension as do some HD readers and writers. Would I trade my current fixed pension for a 401k plan, would you?  Not back in 1961 I wouldn’t have, but if I was entering the workforce today, I think it might be different. 

My pension plan was started in 1911, funding began in 1967. It is well funded. Like me it is a dinosaur. My pension is based on nearly 50 years of service with one company and the benefit is calculated on five years of my highest salary, and a portion of cash bonus compensation as well – those days are long gone. Even my old employer no longer offers such a plan.

Pensions were generally confined to heavily unionized companies – and governments. The majority of Americans never had a pension so the 401k is a great benefit.

The value of a defined benefit pension plan is based on pay, length of service and the plan formula. Long employment with the plan sponsor is key both in accumulating the benefit, but also in earning a non-forfeitable right to what has been accumulated – vesting. 

Defined benefit simply means the plan promises a benefit, and the cost of funding is variable. Defined contribution plans fix the funding cost – if any – for the employer, but make no promise for the eventual benefit. 

Pension plans are designed to reward long service with the plan sponsor, they are typically backloaded meaning the greater benefits are accumulated later in a career.

There has not been a significant change in employment tenure over the years, it is and has been about four years plus or minus a year. That means that a pension plan has little or no value for the average worker because vesting typically occurs after 5 to 7 years of employment.

A typical pension plan requires funding equal to about 8% of covered payroll – many government plans require an employee contribution too. The average employer match in a 401k is 4-6% of salary – the bad news is nearly 60% of employers do not provide a match, but it is highly likely such employers never offered a pension.

This is why a 401k is a valuable retirement tool and certainly much better than no plan at all. Unlike most pensions, a 401k is portable and flexible. Some plans now offer an annuity option within the 401k – the best of both worlds it seems. 

I conclude that a 401k is the best option for most workers today with greater value added if there is an employer contribution – matching or otherwise.