Do Pensions Beat 401(k)s?

A recent study shows that investors aren't doing as well on their own.

Dan Caplinger
Dan Caplinger
Dec 22, 2006 at 12:00AM
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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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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.