Please ensure Javascript is enabled for purposes of website accessibility
Free Article Join Over 1 Million Premium Members And Get More In-Depth Stock Guidance and Research

Surprise! 401(k) Plans Are Actually Better Than Pensions at Doing This

By Dan Caplinger - Mar 2, 2019 at 6:50AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The conventional wisdom seems to be wrong -- in one respect.

Over the past 20 years, there's been a huge shift in the way that companies help their employees save for retirement. Throughout much of the 20th century, many companies concentrated on providing pension plans for their workers, under which retirees would get paid fixed amounts depending on their level of work experience and pay. But more recently, that's given way to companies replacing their pension plans with defined contribution plans like 401(k)s.

Many commentators have bemoaned that shift, arguing that it puts the onus on workers not just to set money aside for retirement savings but also to invest that money effectively over the course of their careers. But as it turns out, 401(k) plans can be more effective than pensions in providing financial stability in retirement -- if they're used properly.

Jar holding money with green sticky labeled Retirement, next to a calculator.

Image source: Getty Images.

401(k)s get no love

It's easy to find anecdotes about workers who've made mistakes in managing their money and have therefore found that their 401(k) plan accounts didn't grow sufficiently to meet their financial needs in retirement. That's not terribly shocking, given the baseline that old-style pension plans used to provide.

With a pension plan, it's up to the company to figure out how to save and invest in order to meet its future financial obligations. Companies are generally required under accounting standards to set money aside on a regular basis toward covering pension obligations, but the manner in which they invest the pension money is open to a wide range of possibilities. The consequences of failure, however, remain on the company: If there's not enough money to pay pension benefits as they come due, then it's up to the employer to make up the shortfall.

401(k) plans flipped those responsibilities on their head. Employees are responsible for making the bulk of contributions to their retirement, with companies simply adding on some extra money in the form of matching contributions or profit-sharing. Moreover, it's up to employees to choose from a menu of investment options in their pursuit of sufficient returns to help their money grow over time. Fall short, and employees have no one to blame but themselves.

The truth behind 401(k)s

Yet research from the Employee Benefits Research Institute found that 401(k) plans can actually be more effective in producing retirement income than traditional pensions. The EBRI compared two situations, one involving a 401(k) plan that included automatic enrollment features that ensured that new employees would participate, and the other involving a traditional defined benefit pension plan whose payments were based on the average pay workers earned during their final three years of employment.

The results were surprising. Researchers found that in order to match the performance of an auto-enrollment 401(k) plan, most pension plans would have to feature accrual rates of 1.5% per year of service or more. Yet with typical pension plans, actual accrual rates are rarely that high. EBRI looked at 16 different combinations of worker pay and years of experience, and in only a small number of them were the break-even accrual rates under that key 1.5% number -- just two for male workers and five for female workers.

Potential problems with 401(k)s

However, 401(k) plans aren't perfect. EBRI also found that there are situations in which pensions perform better:

  • Most pension plans have options that pay benefits for the rest of a retired worker's life. That makes longer-lived retirees more likely to get extra money from a pension, making it superior to a 401(k) plan.
  • During periods of weaker returns for the financial markets, pension plans can regain a competitive edge over 401(k) plans from the worker's perspective.

Nevertheless, it took relatively extreme cases in these situations to move the needle significantly. For the most part, 401(k) plans demonstrated their relative superiority.

You can't win if you don't play

The most important takeaway from the EBRI's research was that in order to make your 401(k) outperform, enrolling was crucial -- and automatic enrollment into appropriate investment options took away one of the biggest obstacles to retirement security. If you have access to a 401(k) plan but don't have automatic enrollment, it's up to you to take full advantage of that benefit. Without it, you'll be a lot less prepared for retirement.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
624%
 
S&P 500 Returns
140%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 12/05/2021.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Our Most Popular Articles

Premium Investing Services

Invest better with the Motley Fool. Get stock recommendations, portfolio guidance, and more from the Motley Fool's premium services.