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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.
I agree that I think most people are probably better off with the 401k for the reasons you mentioned. Your arguments are pretty similar to those the federal government offered when the federal CSRS retirement plan was replaced by FERS in the early 1980’s. Basicly, the federal pension was reduced by half but federal employees started participating in social security and received a 5% match in the thrift savings plan. Some folks were better off under the old plan, but some folks were better off under the new plan. It really depended on whether you spend an entire career as a fed, or only a partial career. In the case of a partial career (consistent with the modern reality) the newer plan was generally considered better.
What I like about FERS, its not an either/or: its both a pension and 401k.
Thanks for this interesting article and conversation, Dick and others. I didn’t know some of the information. We were caught by the change from pensions to 401ks more than some of the HD folks. Luckily none of the mistakes we made were fatal, but it took a long time to catch up. Chris
I have a DB pension, a 401k and SS – the traditional three legged stool. Unfortunately, since the pension has no COLA, that leg keeps getting shorter. Of course, the ideal would be a DB pension with a COLA plus SS, but apparently that has never been available in the private sector in the US (unlike the UK).
While I agree that a DB pension isn’t a good fit in a world where companies no longer want to retain employees long-term, and employees often prefer startups or the gig economy, I don’t think the 401k is an especially good substitute. It wasn’t even designed as a substitute. We see occasional fixes, such as automatic signup and even automatic investment choices, but it still relies too heavily on the financial knowledge and discipline of workers who may live paycheck to paycheck.
Rather than tax breaks for 401k contributions I would prefer a more robust SS system, with higher payouts for lower paid workers and no cap on the income base for deductions.
IBM is taking an interesting tack, which appears to be entirely in its own financial interest. It’s a pity they couldn’t have used some of the funds in the pension plan to provide increases for retirees, rather than replacing their pensions with annuities.
The traditional 3-legged stool was pension, SS and personal savings long before there was a 401k.
‘’Again, keep in mind only about 50% of workers ever had a pension so it was great for many people. When the 401k began in the early 80% large employers with pensions added it as an additional benefit. It wasn’t until the accounting rules changed and finance guys got more involved that the impact on earnings volatility and funding became an issue and started the demise of pensions among large employers.
I know it’s true, but I see little excuse for workers not to exercise discipline and responsibility for their retirement. A minimal of effort is required and these days there is more information available than any other time.
A greater role for SS is part of the retirement solution, I agree, but the formula already benefits lower earners and even eliminating the taxable wage base has quite limited impact on the shortfall we now face. In other words, to fix and then improve SS requires significant tax increases.
Last year my previous employer purchased annuities in lieu of the pensions of employees in a major subsidiary. The retirees were not harmed and the employer was relieved of the entire liability.
I wrote about the IBM strategy last year. It has been cutting regularly for many years.
How people think other people should behave, and how they actually behave frequently differ. Policies need to address the probable rather than the ideal.
BTW, the article I linked said that 62% of US workers had DB pensions in the 70s.
If you include government workers.
Are you suggesting that government workers aren’t workers?
Exactly….very insulting.
No, the stats from the BLS are divided into public sector (government) and private sector. That’s all.
What are you referring to, what’s insulting? That public sector workers have and always had higher percentage of pension coverage?
I would imagine it’s your failure to include them in your statement about “workers”. Going forward please revise your claim that 50% of “workers” used to have pensions to the actual 62%.
Oh my.
The BLS breaks much of its data between private sector and public sector workers. Public sector workers have pension plans at a much higher rate. Even today it’s close to 90%.
True, but very misleading. I know in my state most public service employee’s (maybe all) in the state pension system aren’t covered by social security (unless they have some other job).
Great article Dick. Wen GE added a 401k with a 50%match of the first 8% saved, and continued their DB pension, I knew I was fortunate. Through 3 mergers and being sold. we kept the BD pension for 31 of my years. We always saved as much as we could in the 401k, maxing it out once we got the kids through college. The hospitals and medical management companies my wife worked for moved to DC plans, and gradually added a small employer match. Luckily, we were in a position to max both of our 401ks during the 2007 GFC and recovery. That helped a lot.
This is very true. A pension is nice if you can last the 30 years needed to get full benefits, but that is often beyond one’s control in a corporate environment. A 401k is definitely preferred, but you have to be proactive and to get the most out of them you have to start early, choose an age-appropriate allocation and fund it aggressively.
Additionally, the “golden handcuffs” issue is real. I’ve known a number of folks who were miserable in their final years of their employment, but did not want to change jobs because they could not afford the loss of pension income that would entail.
Sometimes the golden handcuff worked in reverse by retaining workers the employer would happy to see go.
Even worse, our company would every few years have cutbacks with generous payouts (1 month salary for every 2 years of service). So it wasn’t unusual to see older employees with fully vested pensions waiting for the cutbacks to occur and volunteering for them. It was almost treated as an entitlement at some point.
I engineered four such early outs for my employer as they were called and none went as planned and none actually saved money. The most experienced skilled workers were lost, tons of OT was necessary until they were replaced and it took years to recover.
I guess that’s why by the time it became my turn, the companies had stopped doing them.
Dick, you get kudos for consistently pointing out that there never was a universal golden age for pensions, at least in the private sector. Although to be fair, the industry you and I both worked in did enjoy one until a couple decades ago. Before I started in the industry, I was told if someone could manage to stick around for 5 years, they usually would stay to 35 (years of service). Those days are long gone, hence the 401(k) is a better fit for today’s generation of workers. It’s not much help in retaining a skilled workforce, which is something the pension did well.
Of the four companies I worked for during my career (five if you include an acquisition), only one offered a pension. There was a layoff before I vested in the pension, and I was already looking for another job to leave that company. If it weren’t for the 401(k) program at all of them (and an IRA-SEP option at one small business) it would have been more difficult to keep my eye on the retirement horizon. I wrote about this in a HD article here.