Better Bet. A Pension or a 401(k)?

In a previous post, I posed the question, “What is Your Pension Worth?” I noted that if you are on track to receive a pension (i.e. defined benefit plan), it is likely that your employer has provided some guidance as to what your projected pension will be, or if you are like me, you have done the calculation yourself based on your employer’s benefit formula. Most benefit formulas consider factors such as the number of years of employment, pay and a given percentage.

Computer Screens

As an example, my employer uses the following formula for those that retire before age 62: 1% × High-3 Average Pay × Years Service. This is how it would look for someone who worked 30 years, 4 months (4/12 years or 30.33) when their highest three years – typically the final three – of salary averaged $100,000 … .01 × 100,000 × 30.33 = $30,330.

But what would be the dollar value of that $30,330 be in retirement? In other words, we typically track the value of our retirement plans (e.g. 401(k) and IRAs) and have a target number (e.g. $500,000) in mind for the day we retire. How would we convert that $30,330 pension to a comparable defined contribution plan number? Is a $30,330 annual pension equivalent to a $500,000 401(k) account balance? Is it worth more, less?

I then provided some suggestions as to how you might compare the two.

Disregarding that measure of worth, what if we thought about worth, or the value, in a different way. What if we thought about worth in terms of the likelihood that you will actually get that $30,330 annual pension or the full benefit of a $500,000 401(k)? In other words, as you look into your cloudy crystal ball, which do you believe is a better bet?

Not too long ago I would have said a pension is more valuable. Why? They are guaranteed, silly. Whereas with a 401(k) or another defined contribution plan, you have to contribute over the course of 20 – 30 years and ride the vagaries of the stock market. Other than the fact the account belongs to you, nothing about the final balance is guaranteed; that’s what makes planning so difficult when a 401(k) is the centerpiece of your retirement plan. Conversely, with a good ol’ pension you simply put in your 20 – 30 years, apply the formula as you get toward the end of your career and sit back, fat and happy, knowing how much you’re going to get. Pretty straightforward, right? Not so fast. What if that guarantee wasn’t really guaranteed?

Unfortunately, that is the world we currently inhabit. Defined benefit plans are in real trouble and they certainly aren’t guaranteed. Just ask employees of AIG, Kodak, Lockheed Martin, Allstate, Macy’s, and Sysco just to name a few. Here is one list of 100s of companies, since 2005, who have changed their defined benefit plans for current employees.

As Derek at Money Ahoy noted in a comment on a recent post, “I have a defined pension from my job, but they slashed it years ago so now it is only one-third of what it used to be. I haven’t run the numbers, but I have the feeling it will basically cover my gas money each month when it comes time to collect This is also especially true as I plan to retire early!”

Not only are plans changed for current employees, they can be changed for those that are already retired. Just ask former municipal workers for the city of Detroit or the state of Rhode Island …

In 2012, then Governor Lincoln D. Chafee and State Treasurer, now Governor, Gina M. Raimondo called for a dramatic rollback in the pension benefits anticipated by more than 51,000 past and present government employees in Rhode Island, including state workers and public school teachers.

A bulletin from the Social Security Administration notes: The percentage of workers covered by a traditional defined benefit (DB) pension plan that pays a lifetime annuity, often based on years of service and final salary, has been steadily declining over the past 25 years. From 1980 through 2008, the proportion of private wage and salary workers participating in DB pension plans fell from 38 percent to 20 percent (Bureau of Labor Statistics 2008; Department of Labor 2002). In contrast, the percentage of workers covered by a defined contribution (DC) pension plan—that is, an investment account established and often subsidized by employers, but owned and controlled by employees—has been increasing over time. From 1980 through 2008, the proportion of private wage and salary workers participating in only DC pension plans increased from 8 percent to 31 percent (Bureau of Labor Statistics 2008; Department of Labor 2002). More recently, many employers have frozen their DB plans (Government Accountability Office 2008; Munnell and others 2006). Some experts expect that most private-sector plans will be frozen in the next few years and eventually terminated (Aglira 2006; Gebhardtsbauer 2006; McKinsey & Company 2007).

Pension_Protest

Not only has the number of companies that offer them been decreasing since the early 1980s, many of the plans that are in place have been underfunded, plan administrators have been too optimistic with the projected returns, or some combination of those two factors. Note that participants in both government (local and state) and private industry plans are being impacted. And what happens when the sponsor – the employer – of the plan can’t meet its obligations? Simple. It changes the terms (e.g. requires increased contributions from employees, changes the formula, reduces the benefit, etc.) for current employees and may reduce the benefit for retired employees … never mind what was contributed or promised.

You don’t have to look very far to find numerous examples. I wrote about the issue in the post titled Pensions. Going, Going … and in numerous posts about the city of Detroit, the most well-known recent example. Simply search for ‘Pension Crisis’ utilizing your favorite search engine and you will find numerous articles, studies and reports on the topic.

Do you have access to a defined benefit plan? a defined contribution plan? Both? If you have access to a defined benefit plan, do you have concerns the terms of the plan will change between now, the time you retire or worse yet, after you retire? Which do you believe is more likely to be the primary investment account from which you will draw retirement income?

Blogger-in-Chief here at RetirementSavvy and author of Sin City Greed, Cream City Hustle and RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit.

13 Comments

  1. Like Mr. Groovy, I have will have a pension with the state of New York. I think it’s relatively stable compared to other states and I think it is guaranteed by the state constitution so it would be tough to slash benefits compared to the private sector. Not impossible but less likely. It is a great benefit but sometimes I’m not sure if I might not prefer a company with a great 401k plus matching. That way the money is yours and you don’t have to fret about the company going under or them slashing your pension. Plus, having a pension can be a bit of a handcuff…albeit a golden handcuff. It’s tough to leave a job and leave that pension!

    • I’m lucky in that I have a job that provides both. Because of the fact that there are a number of ways in which investment/retirement accounts can be negatively impacted, it is crucial to develop as many streams of income as possible.

  2. What I like about a pension is it’s typically guaranteed, based on years of service or % of your base salary; but many companies are doing away with them.

    • “What I like about a pension is it’s typically guaranteed … .” Agreed. However, the problem is that many sponsors are changing the terms of the plan for current and retired workers. They aren’t as ‘guaranteed’ as many people believe. As I noted in another post, on a different topic, but applies here as well, “And therein,” as the bard would tell us, “lies the rub.”

      And of course, as you note, many companies are doing away with them completely or have stopped offering them to new employees.

  3. Thanks for the mention James!

    Just as an update to my previous comment. My employer is now actively trying to merge with another company. I have no doubt that during the merge they will do their best to “raid the coffers” and somehow take the pension away from folks that it was promised to. Just another notch in the belt for the 401(k)!

    • Thanks for stopping by and providing the update. Hopefully the merger won’t have a detrimental impact to your plan.

  4. Hey, James. Great point. Even guaranteed pensions aren’t guaranteed. I have a small pension from New York sate that will start this October ($20K annually). It’s my understanding that New York’s public-sector pension plan is relatively well-funded (at least compared to Illinois). But things can change quickly. The state will probably hit health care coverage for retirees before it starts chipping away at pensions.

    There’s no easy answer. Mrs. Groovy and I are preparing for the worse. We’re assuming my New York state pension is play money. We’re not basing our retirement calculations on it. If it’s there, great. If it’s not, oh well.

    It sucks that people have to be so defensive, but the alternative is worse. Thanks for putting this concern on our radar.

    • “There’s no easy answer. Mrs. Groovy and I are preparing for the worse. We’re assuming my New York state pension is play money. We’re not basing our retirement calculations on it.” Absolutely the way to play it. As I note in Multiply Your Streams of Income, our plan is to have 10-12 different income streams in retirement with the expectation that one or more will be negatively impacted over time by forces beyond my control. Relying too heavily on one source, regardless of how secure you believe it will be, is setting yourself up for disappointment and has the potential to place you in a precarious situation financially.

  5. If pensions were guaranteed, pensions would have been the better option. The ability however of pensions getting wiped out or reduced through the multitudes of loopholes/bankruptcies makes them no longer viable (in my opinion). If you are planning to work till 65, 401(k)s are just fine. You are in control yourself which unfortunately, is not good for everyone. The ability to loan against your 401(k) has made it a risky business for some.

    If you’re planning to retire early make sure you get a good mix of 401(k) and after tax investments. I invested too much in my 401(k) and too little in after tax stock to make it all the way to 59.5. I’ll need to jump through some loopholes myself to get to my 401(k) early (without the penalties).

    • All well stated, particularly your observation about 401(k) loans. That is certainly a knock against them as too many people fail to realize the danger of not leaving the money in place. And thanks for sharing your experience, my friend.

  6. Thanks for a great analysis. It draws some parallels to insurance as well. An insurer, or in this case a pension, is only as guaranteed as the ability of the provider to pay. People tend to not take this part of the equation into account.

    • Exactly. What the example of Detroit, Rhode Island, numerous municipalities and numerous corporations should teach us is that nothing is guaranteed. As the old saying goes, “Don’t put all your eggs in one basket.” As I remind people in one of my best received posts, Multiply Your Streams of Income, it is important to generate multiple streams of income, both during your working and retirement years.

      Thanks for sharing your thoughts, my friend.

      • Absolutely, that is one of the best things that people can do from a personal risk management perspective. If an investment goes south or benefits don’t come as promised, then it drastically improves your chances of success when you have other ways of bringing money in.

        Thanks for the link. Another great article. I’ve added this one for reference as I get on this topic pretty regularly with friends. It will be good to add another source to my arsenal on the topic.

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