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.
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.
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 onlyDC 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).
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?