Pensions
Vs.
401 (k)
MG100
Julie Sievert
Table of Contents
Contents
Introduction.................................................................................................................................... 3
What is the difference in retirement plans? .................................................................................. 3
How did we come to have 401 (k)’s in the first place? ................................................................. 3
Why have traditional pensions been so widely abandoned besides the cost savings for
corporations?.................................................................................................................................. 3
Are all retirement plans now contribution plans? ........................................................................ 4
What are the pros and cons of retirement plans? ......................................................................... 4
Which retirement plan gives the best return? ............................................................................... 5
Conclusion...................................................................................................................................... 6
Bibliography ................................................................................................................................... 7
Pensions vs. 401 (k)
Introduction
30+ years ago, your employer would help you in your retirement years by providing a pension
plan through them. With funding problems at companies like United, Ford, and EDs, employers
have moved toward contribution plans like 401 (k)’s (Caplinger, 2006). Why did we go from
traditional pensions to employee contribution plans?
What is the difference in retirement plans?
A defined benefit plan is a pension that companies agreed to pay their employees a
certain monthly amount at retirement.
A defined contribution plan is a 401(k) in which employees play a more active role in
setting aside and investing their monies.
These plans allow both employers and employees to make contributions toward
retirement goals (Caplinger, 2006).
How did we come to have 401 (k)’s in the first place?
“401 (k)’s were never designed to be a retirement plan for millions of Americans. They were
created in the late 1970’s “as a tax shelter for ordinary Americans”. It was revealed that 401 (k)
were originally a piece of obscure special-interest legislation, an arcane paragraph in the 1978
Federal Tax Code. It was a technical fix – to protect a tax shelter for Kodak and Xerox
executives. In 1981 under corporate prodding, the IRS ruled that savings from regular workers
also qualified” (Mann, 2009).
The financial-services industry and mutual-fund companies started to promote it. It became all
about “empowering” the small investor. Corporations quickly realized 401 (k)’s would save
them about 50% over pensions (Mann, 2009). In 1978, workers only contributed about 11%
toward their retirement while corporations put in 89% (Mann, 2009). By 2000, employees were
contributing 51% (Mann, 2009). That’s another 40% savings for corporations (Mann, 2009).
Why have traditional pensions been so widely abandoned besides the cost savings
for corporations?
Portability: pensions “worked fine” when the norm was to stay with an employer for a
whole career. They don’t work so well when employees leave the employer or switch
careers. Unless the employee is vested (usually 5 years of service), quitting a pension job
can mean leaving with nothing to show in your retirement (Thoughts on 401k Plans vs
Traditional Pensions, 2009).
Contributions Requirements: funding gaps in pensions are filled by the employer. Each
year the plan is assessed and lacking funds must be paid by the employer (Thoughts on
401k Plans vs Traditional Pensions, 2009)
Sustainability: pensions are lifetime promises, work long enough to qualify, and the
sponsor guarantees you a monthly annuity payment for the rest of your life. Longer life
expectancies, accumulative costs of benefits, and global competitive pressures spurred
companies to rethink the sustainability and risk of funding lifetime pension promises
(Thoughts on 401k Plans vs Traditional Pensions, 2009).
Are all retirement plans now contribution plans?
Many state and local governments did keep pensions. Many or most of these plans will be
forced to raise taxes to fund lifetime promises made to millions of public employees. These tax
increases will fall upon the tax payers, whose own retirement accounts have been severely
eroded (Thoughts on 401k Plans vs Traditional Pensions, 2009). To make matters even worse,
the taxpaying public will learn just how rich these government pensions have become. Pensions
have been dubbed the “gift that keeps on giving” because of seemingly never-ending benefit
improvement (Thoughts on 401k Plans vs Traditional Pensions, 2009). The administrative
efficiencies that pension supporters point to are marginalized when retirement ages are
negotiated lower, expensive cost of living allowance (COLA’s) introduced and “multipliers”
enhanced on a regular basis (Thoughts on 401k Plans vs Traditional Pensions, 2009). If it was
possible to set pension benefits at a uniform and moderate level, not subject to bargaining and
“enhancement”, pensions still might prevail in the corporate sector.
What are the pros and cons of retirement plans?
The present financial crisis severely highlights the pros and cons of pensions and 401 (k)’s.
What might be considered the predictable, largely guaranteed income of pensions and the sharply
contrasting 401 (k)’s with their day-to-day fluctuating account values, which are now bringing
havoc to planned retirements (Glickstein, 2008).
401 (k)’s have only been around for 30 years, that means that we’ve not had a generation of
workers retire on all or mostly 401 (k) assets (Glickstein, 2008). Employees invest their assets as
individuals in 401 (k)’s. As they approach retirement, they have to construct paths for reducing
their risks in their accounts and provide some measure of predictable income for their retirement
(Glickstein, 2008).
Companies that sponsor pensions are investing as one large pool and a longer time line than is
the case of individual employees. This enables them to more easily deal with market downturns.
Additionally, the assets of pensions are guaranteed by the company and, in the case of most
benefits, by an agency of the federal government with an additional layer of security (Glickstein,
2008).
Individuals undergo the risks of 401 (k)’s and companies assume the risk of pensions. Those
employees who rely on 401 (k)’s more likely to be worrying about their financial security, and
during difficult times, the situation may create a drain on morale and productivity (Glickstein,
2008).
Which retirement plan gives the best return?
The Center for Retirement Research (CRR)at Boston College study looked at the rates of return
for participants of both retirement plans between 1988 and 2004 (Caplinger, 2006). By looking
at the IRS forms that all large retirement plans must file annually, the study was to determine the
returns for a broad sample of retirement plan participants.
At first glance, the study found that median rates of returns were relatively similar for pensions
and 401 (k)’s (Caplinger, 2006). However, when the CRR gave the returns of larger plans
greater weight that those of smaller plans, the results showed that pensions had a significant edge
over 401 (k) plans; the excess return was a full percentage point (Caplinger, 2006). The study
concluded that one reason for this was that larger defined plans may be able to hire better
investment managers.
The CRR wanted to look deeper into the root causes of why pensions outperformed 401 (k)’s.
One possible reason would be that if defined plans invested more aggressively than 401 (k)
participants. The asset allocations in both types of plans, for the most part, were relatively
similar.
Another difference was that while pensions tended to invest mostly through individual stocks
and fixed-income securities and 401 (k) participants tended to have a much higher percentage of
assets in mutual funds (Caplinger, 2006). The use of mutual funds adds management fees that
direct stock and bond investors don’t have to pay. It’s reasonable to conclude that these fees
(often exceeding 1%) reduced investor performance (Caplinger, 2006). That 1% per year could
be about a 20% reduction in your retirement (Wicai, 2006). Fees, measured as a percentage of
assets, tend to decline as account balances and number of participants increase (Thoughts on
401k Plans vs Traditional Pensions, 2009). 401 (k) plans have fixed administrative costs
necessary to run a plan that tend to cause smaller plans to have a higher fee (Thoughts on 401k
Plans vs Traditional Pensions, 2009). As a plan grows in size, economies are gained which
spread the fixed costs over more participants and a larger asset base (Thoughts on 401k Plans vs
Traditional Pensions, 2009)
The study found that nearly half of all 401 (k) participants have either all or none of their money
in equity investments. These findings raise grave concerns that many plan participants are not
diversified enough. Although these plans may give informed investors greater latitude in
tailoring their retirement asset decisions, it is apparent that many investors lack a complete
understanding the risks and rewards involved in retirement investing (Caplinger, 2006).
The CRR study underscores the need for employees to understand and take full advantage of
their retirement plan options (Caplinger, 2006). Employees must take responsibility for coming
up with a viable retirement strategy that will allow them to make the most of their retirement
(Caplinger, 2006).
Conclusion
It is easy to see why employers have gone with employee contributive plans. They travel with
the employee when they leave the company, and they are financially better for the company.
However, it is just one more thing the employee has to learn how to do. Retirement funds need
to be diversified and they need to be watched in times of distress. It is up to employees to make
sure that their nest egg is doing the best it can. They need to stay in tune with today’s economy
and to make appointments with their brokers to discuss their options. Confusion is not an option.
Bibliography
Caplinger, D. (2006, December 22). Do Pensions Beat 401 (k)'s? Retrieved November 9, 2009,
from The Motley Fool: http://www.fool.com/personal finance/retirement/2006/12/22/do-
pensions-beat-401ks.aspx
Glickstein, A. (2008, November 4). Reconsidering Pensions Vs 401k Plans. Retrieved November
9, 2009, from Insurance Quotes: http://www.howard-ballast.com/reconsidering-pensions-
vs-401k-plans
Mann, B. (2009, April 23). The Parts of The 401 (k) Disaster Story 60 Minutes DIDN'T Report.
Retrieved Novmer 9, 2009, from The Huffington Report:
http://www.huffingtonpost.com/bill-mann/the-parts-of-the401k-dis_b_190694.html
Thoughts on 401k Plans vs Traditional Pensions. (2009, October 31). Retrieved November 9,
2009, from 401k Planning: http://www.401kplanning.org/thoughts-on-401k-plans-vs-
traditional-pensions/
Wicai, H. (2006, September 5). Pensions vs. 401ks. Retrieved November 9, 2009, from
Marketplace From American Public Media:
http://marketplace.publicradio.org/display/web/2006/09/05/pensions_vs_401ks