7/15/2013 2:45 PM ET|
Which is better: 401k or a pension?
Managed correctly and over a sufficiently long haul, 401k's can produce more money at retirement than traditional private-sector pension plans, new research suggests, though the risks are obviously higher.
Most people bemoan the loss of the traditional pension plan, and they cite its disappearance -- and the rise of the save-it-yourself 401k -- as key factors in the retirement crisis facing American workers. But new research suggests the new kid on the block is not to blame.
In fact, workers with 401k's in some cases are likelier to end up with more money at retirement than they would with a traditional private-sector pension plan, according to a study by the Employee Benefit Research Institute, a nonpartisan think tank in Washington.
Some people "have termed 401k's a failed experiment," said Jack VanDerhei, a research director at EBRI and author of the report.
"But it's just not what the evidence is suggesting," he said.
For example, lower-income workers who are now aged 25 to 29 and who remain eligible for their retirement plan for 30 to 40 years end up with a 15 percentage point higher income-replacement rate at retirement with a 401k than with a traditional pension plan, according to the study's median finding for that scenario.
"Replacement rate" means the percentage of annual income they'd be able to create from their account balance at retirement. (As an example, unrelated to the study, 80% of income is replaced versus 65%.)
A 401k is even more valuable for higher-income workers, the study shows.
Under the same scenario as above, but looking at workers who earn more, the difference in income replacement rates at retirement rises to 21 and 30 percentage points more for 401k's over pension plans, at the median, for people at the next two income quartiles.
The study found a hefty 44 percentage-point gain in favor of 401k's for workers at the highest income level, according to the median finding for the above scenario.
In the above scenarios, the EBRI study assumed historical rates of return on an equities and bond portfolio, and historical annuity costs. (In order to compare 401k's to traditional pension payouts, the research assumes that retirees purchase annuities at age 65.)
The report is based on data for more than 2 million plan participants, and accounts for the fact that not all people who have a 401k choose to save money in it.
If the study focused only on those who save, VanDerhei said, "that would clearly alter this and 401k plans would always do much better, especially for low-income workers."
But if you reduce the assumed rate of return, the traditional pension starts to look better for lower-income people, the study found.
For example, when the rate of return is decreased by 200 basis points, a 25- to 29-year old lower-income worker who is eligible for a plan for 30 to 40 years would see his income replacement rate at retirement with a 401k plan drop to 4 percentage points lower than he would have enjoyed with a pension plan, at the median.
For the next highest income group in the above scenario, their replacement rate with the 401k would be 1 percentage point less than with a traditional pension.
However, for the two highest-income groups, the 401k is still better: that plan provides a 6 percentage point and 15 percentage point replacement-rate benefit over the pension, at the median, even when a lower rate of return is assumed.
And combining the lower-return assumption with a higher-cost annuity assumption (reflecting the current low-interest-rate environment, which is substantially different from recent history), then traditional pensions look even better.
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