Do Pensions Beat 401(k)s?

It would be nice if modern financial innovations were all better than past practices. For instance, in the past, most employers used defined benefit plans, in which companies agreed to pay their employees a certain monthly pension amount at retirement. With funding problems at companies like United (Nasdaq: UAUA  ) , Ford (NYSE: F  ) , and EDS (NYSE: EDS  ) , however, employers have moved toward defined contribution plans like 401(k)s, in which employees play a more active role in setting aside and investing their retirement nest eggs. These plans allow both employers and employees to make contributions toward retirement goals.

A recent study by the Center for Retirement Research at Boston College examined whether employees with defined contribution plans fared better than their counterparts with defined benefit plans. Unfortunately, the results suggest that 401(k) plan participants aren't doing as well as employees who have access to traditional defined benefit plans.

What the study saw
The CRR study looked at rates of return for participants in both types of retirement plans between 1988 and 2004. By including both the long bull market that followed the stock market crash of 1987 (with its small corrections in 1990 and 1994), as well as the bear market from 2000 to 2002, the study sought to include a full range of investment conditions in its research. By looking at the IRS forms that all large retirement plans must file annually, the study was able 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 defined benefit and 401(k) plan participants. However, when the CRR gave the returns of larger plans greater weight than those of smaller plans, the results showed that defined benefit plans had a significant edge over 401(k) participants; the excess return was a full percentage point. The study concluded that one reason for the disparity was that larger defined benefit plans may be able to hire better investment managers to produce higher returns on plan assets.

However, the CRR wanted to look deeper into the root causes of why defined benefit plans outperformed 401(k) plans. One possible reason would be that if defined benefit plans invested more aggressively than 401(k) plan participants, the greater exposure to equities and other riskier assets would justify their higher return. However, in looking at the asset allocations of defined benefit plans versus 401(k) plans, the study found that, for the most part, overall allocations in both types of retirement plans were relatively similar over the period, with 401(k) plans actually having a higher percentage of assets invested in stocks and stock mutual funds during several years.

Another difference was that while defined benefit plans tended to invest mostly through individual stocks and fixed-income securities, defined contribution plan participants tended to have a much higher percentage of assets in mutual funds. Because the use of mutual funds adds a layer of management fees that direct stock and bond investors don't have to pay, the study looked at the question of whether higher fees for 401(k) plan participants accounted for the lower return. Since fund expense ratios for stocks often exceed 1%, it's reasonable to conclude that these fees reduced investor performance.

Moving beyond the totals
Although the overall conclusion that defined benefit plans tend to outperform 401(k) plans was disappointing, perhaps more surprising was the study's examination of individual plan participants. The study found that nearly half of all 401(k) plan participants have either all of their money or none of their money in equity investments. While the overall asset allocation of 401(k) plans suggests a reasonable balance between stocks, bonds, and cash, these individual findings raise grave concerns that many plan participants have virtually no diversification in their retirement portfolios across asset classes. Even if 401(k) plans give informed investors greater latitude in tailoring their retirement asset decisions to their own particular financial situation and goals, it is apparent that many investors lack a complete understanding of the risks and rewards involved in retirement investing.

Moreover, although the study was unable to get detailed information on IRA accounts, a brief examination of available data suggests that IRA investments may be doing even more poorly than 401(k) plan investments. There are several legitimate reasons why IRAs might underperform other retirement assets, the most obvious of which is that a significant amount of IRA money is held by older retirees who have rolled over retirement plan assets into an IRA account. These older retirees tend to have more conservative asset allocations than younger plan participants who are still working and accumulating wealth to cover retirement expenses.

The researchers noted that to the extent that employer-sponsored retirement plan assets represent only a portion of a person's overall assets that are earmarked for retirement, looking only at the allocation of plan assets may provide a misleading picture. However, the study asserts that for most workers, their 401(k) plan balance represents the vast majority of their retirement assets.

The CRR study underscores the need for employees to understand and take full advantage of their retirement plan options. Even if going back to defined benefit plans might be better for many workers, it is unlikely that the current trend toward 401(k) and other defined contribution plans will reverse itself. Like it or not, employees must take responsibility for coming up with a viable retirement strategy that will allow them to make the most of their retirement.

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If you're looking for guidance on how to establish a successful retirement strategy, the Fool's Rule Your Retirement service can help. Foolish expert Robert Brokamp and his team of knowledgeable writers will tell you what you need to know to make the most of your employer's retirement plan, including how to make investment choices. You can take a look at Rule Your Retirement today with our free trial.

Fool contributor Dan Caplinger has a lot of fun managing his 401(k) plan accounts. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy tells you everything you need to know.

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  • Report this Comment On November 14, 2008, at 12:43 PM, sanserve wrote:

    Let's Make 401(k)s And IRAs More Like Pension Plans

    Who's confiscating your 401(k) and IRA? Dateline Raleigh, NC, November 6, 2008: Democratic leaders in the U.S. House of Representatives discuss confiscating our 401(k)s and IRAs, by Carolina Journal Online reporter Karen McMahan.

    This shocking pronouncement is certainly an attention grabber, which if even partially true, would have an impact on nearly every employed and retired American. The basis for the report is testimony before the House Committee on Education and Labor in early October.

    Dr. Teresa Ghilarducci is one of many witnesses (scholars, retirees, activists, an investment mogul, and benefits experts) who were interviewed by the committee members. (I was skipped over once again, but a receptive person in the HCEL was willing to forward a listing of my articles to the right person. I expect an invitation to testify momentarily)

    McMahan writes: "Dr. Ghilarducci, professor of economic policy analysis at the New School for Social Research, drew the most attention and criticism. She proposed that the government eliminate tax breaks for 401(k) and similar retirement accounts, such as IRAs, and confiscate workers' retirement plan accounts and convert them to universal Guaranteed Retirement Accounts (GRAs) managed by the Social Security Administration."

    Several people have asked me to comment on the probability of such a radical approach ever getting any support, much less actually being implemented. Most feel that even the most socialistic of legislators would give the doctor's ideas a quick thumbs down. I agree that they should, but part of the concept, tuned up "capitalistically", could be precisely what this investment doctor would order.

    Years ago, a not-quite-as-sophisticated-as-the-internet rumor mill spread a story that the Feds were scouring the countryside, knocking on doors, and confiscating $100 bills. The purpose of the venture was to put an end to the income-tax-dodging underground economy of the 80's. Babysitters panicked, restaurateurs iced their C-notes in freezers, and self-employed franchisees plotted Caponesque money laundering schemes.

    Nothing happened then that a 10% (or lower) Federal sales tax (coupled with seriously lower income taxes at all levels) wouldn't cure today. So as scary as a 401(k) or IRA confiscation plan would be now, the panic will likely fade quietly away, just like the $100 bill outrage of the 80's. The underground tax dodging continues, and at a magnitude that dwarfs any temporary tax relief that is afforded today's self-directed savings plans.

    One would think that, as a society, we would be capable of pouncing upon opportunities for brilliant solutions to problems of fairness like these. We just can't seem to get out of our own political way. The fix to the retirement investment account fiasco is only slightly more complex than the incredibly easy solution to Social Security.

    Dr. Ghilarducci has presented a socialist solution to a problem that could easily be dealt with using rudimentary controls that would limit the amount of risk allowed inside these tax deferred savings devices. She also ignores the fact that most self-directed money lies in voluntary, privately sponsored, employee benefit programs--- emphasis on voluntary and private.

    Self-directed retirement accounts could be controlled as to content and asset allocation to: 1) assure that a reasonable proportion of all accounts are guaranteed as to principal and interest, and 2) preclude ownership of high-risk securities.

    I'm not sure that the good doctor grasps the distinction between a self-directed, defined-contribution, investment plan and a guaranteed, defined-benefit, pension plan. Most plan participants are led to believe that the former is just as secure as the latter. Sorry, Charlie.

    The problems are to control the speculative enthusiasm of the unqualified self-directors, and to create a way for captive beneficiaries of the phantom Social Security trust fund to augment their guaranteed retirement benefits.

    A few simple standards would create a whole new set of conservatively managed "retirement plan only" mutual funds, with reduced management fees--- in deference to their captive audience and less speculative composition. Plan participants would not be able to speculate with their savings as they are today.

    Some form of oversight would be needed to assure that no raw speculation was allowed into the new breed of standard mutual funds and CEFs. Instead, Dr. Ghilarducci visualizes all your no-longer-self-directed money finding a new home in the Social Security Administration's toy chest--- thus transforming a behemoth bureaucracy into an investment management giant! This is just too alarming for words---

    But, what if, instead of a Guaranteed Retirement Account, we adopted a whole new system based on the SSRIA? (Google it.) No, it doesn't exist yet, but the private sector could certainly provide it in a commission free, guaranteed income only contract, tomorrow.

    The SSA could oversee the providors, who collectively have thousands of years' experience, and thousands of investment professionals capable of managing guaranteed income vehicles. Just think about it. All employees could opt out of Social Security, and make a smaller, mandated contribution to their one SSRIA.

    Employers could include the SSRIA as an option for both self-directed and matching contributions. Only SIBORAP Tier One securities would be acceptable investments. Existing Social Security balances could be frozen or directed to the personal SSRIAs.

    This approach, admittedly far too simple for consideration, would create thousands of new jobs, eliminate the Social Security funding mess, add billions to personal disposable incomes, and with supervision, allow employers to cut prices, increase salaries and dividends, and create jobs.

    Some would say that this approach can't work with our broken system, as evidenced by the legions of Wall Street fat cats who encourage the creation of toxic products and who routinely pilfer shareholder treasuries for ludicrous sums. Shareholders should solve that problem, not the government--- but the government could help if they chose to.

    Pure capitalism disappeared years ago, traded in for a less efficient, but fairer, regulated version. It's the regulators and their overseers that failed, leading us multi-derivative miles from the pure simplicity of stocks and bonds.

    Steve Selengut

    Professional Investment Management from 1979

    Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"

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